Emerging Trends in Real Estate 2004

Emerging Trends in Real Estate® 2004 25th Anniversary Edition

Urban Land $ Institute Cover Images: Left: Gary Edward Handel + Associates Center: Timothy Hursley/ELS Right: Thomas P. Cox Architects, Inc., Irvine: photo copyright © Steve Hinds Emerging Trends in Real Estate® 2004 25th Anniversary Edition Contents 2 Chapter 1 Borrowing from the Future 3 Sturdy Performance Continues 5 The Economy: Concern about Job Growth 9 Intensifying Unease over an Uncertain World 11 Technology Bites

12 Chapter 2 Investment Trends 2004 13 Time for a Reality Check 14 Core Dominates Opportunistic 15 Best Bets 2004

18 Chapter 3 Real Estate Capital Flows 20 Capital Trends: Equity 22 Capital Sources and Flows 26 Capital Trends: Debt

30 Chapter 4 Markets to Watch 33 Investors Gravitate to the Coasts 33 Hanging on Despite Budget Stress 34 Power, Water, and Oil 34 Is Suburban Expansion Approaching Its Limits? 36 The Best and the Rest

40 Chapter 5 Property Types in Perspective 41 Favored Sectors 43 Thin Development Prospects Narrow Opportunities 44 Retail 46 Industrial 48 Apartments 50 Office 52 Hotels

54 Interview/Survey Participants Editorial Leadership Team Emerging Trends Chairs Editorial and Production Staff Patrick R. Leardo, PricewaterhouseCoopers Bernadette T. Korpacz, Project Coordinator Richard M. Rosan, Urban Land Institute Nancy H. Stewart, Managing Editor Marilyn Robson, Manuscript Editor Author/Editor David James Rose, Associate Manuscript Editor Jonathan D. Miller Byron Holly, Senior Graphic Designer Diann Stanley-Austin, Director of Publishing Operations Principal Researchers and Advisers Peter F. Korpacz, PricewaterhouseCoopers Interview/Survey Participants Dean Schwanke, Urban Land Institute Emerging Trends in Real Estate 2004® represents a consensus Stephen Blank, Urban Land Institute outlook for the future and reflects the views of more than 350 individuals—a record-breaking industry response—who com- Senior Adviser and Publisher pleted surveys or were interviewed as a part of the research Rachelle L. Levitt, Urban Land Institute process for this report. Interviewees and survey participants represent a wide range of industry experts—investors, developers, Senior Adviser property companies, lenders, brokers, and consultants. A partial Robert K. Ruggles, III, PricewaterhouseCoopers list of the participants in this year’s study appears at the end of this report. The people listed there include all of those who Contributing Researchers were interviewed and many of those who returned surveys. To Steven P. Laposa, PricewaterhouseCoopers all who helped, PricewaterhouseCoopers and ULI extend sin- Susan M. Smith, PricewaterhouseCoopers cere thanks for sharing their time and expertise. Without their Richard Kalvoda, PricewaterhouseCoopers assistance this report would not have been possible. John Rea, PricewaterhouseCoopers

Emerging Trends in Real Estate is a registered trademark of PricewaterhouseCoopers LLP.

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Recommended bibliographic listing: ULI–the Urban Land Institute and PricewaterhouseCoopers LLP. Emerging Trends in Real Estate 2004. Washington, D.C.: ULI–the Urban Land Institute.

ULI Catalog Number: E18 ISSN: Pending

ii Emerging Trends Highlights

■ Today’s weak real estate fundamentals will improve very ■ Real estate’s cyclical recovery over the next three to four slowly. Office markets, in particular, will erode further years will be lackluster. Current returns—propped up by before turning around. Corporations’ overseas outsourcing interest rates and capital flows—are borrowing from future and reliance on operating efficiencies to spur profits are performance. restraining U.S. job growth and deepening the hole for most property sectors. ■ Development activity will be limited. Most markets and sectors are oversupplied. ■ Interest rates will rise, putting modest upward pressure on real estate capitalization rates. ■ Developers will find expanding opportunities in urban and suburban infill, as decades of sprawl argue against green- ■ Capital flows into real estate debt and equity markets will field development. lessen, but will remain strong enough to sustain liquidity. ■ Washington, D.C., southern California, and New York are ■ Core property performance will muster returns in the mid the best metro areas for investment. Other markets languish. to high single-digits—comfortably in the black. But portfolios overweighted in office properties with mounting vacancies ■ Of all property sectors, investors favor grocery-anchored could face sizable writedowns. retail, warehouses, and apartments—the cash-flow leaders. Office lags, and retail performance will slack off from recent ■ Foreclosures, delinquencies, defaults, and workouts will highs. multiply during the year, yet remain manageable.

iii Borrowing from chapter 1

“Low cap rates and huge capital flows could be fleeting phenomena. Poor fundamentals may stick around.” the Future o be sure, sustained improvement of commercial real estate markets isn’t likely until 2005 or later, and a shal- Sturdy Performance Tlow, but protracted downturn promises to stress some investors in the meantime. Even as the overall economy signals Continues modest growth, punctuated by a presidential election year of In the near term, annualized core real estate returns will be inevitable pump priming, real estate performance in 2004 quite acceptable—surprisingly good in fact—remaining in the could continue to erode, especially for office investors. “The mid to high single-digits for portfolios concentrated in well- worst is behind, but recovery isn’t imminent.” leased, cash-cow apartment, retail, and warehouse holdings. For 2004, the moods of Emerging Trends interviewees Results will be better—in the low teens—for core investors who range from “cautiously pessimistic” to “at best, less sanguine.” have strategically used cheap debt to leverage up rent revenues Cheerleaders rightly tout the industry’s “resilience”: real estate locked in from recent market peaks. But lower-quality office has delivered positive returns through an entire cycle, surpass- properties suffering high vacancies will likely register value ing stock and bond performance for the last decade. But opti- writedowns—“as much as 25 percent”—and dwindling cash mists must temper their hopes of surfing the cyclical bottom flows. Tenants in all property sectors have substantial bargain- unscathed—despite Alan Greenspan’s largesse and investors’ lining power, and will trade up for quality space at favorable rents. gering doubts about Wall Street alternatives. America’s economy Overall, returns continue to belie those “stinky” market funda- hasn’t shown enough potency to inspire confidence or deflect mentals: the near-record vacancies, falling rents (plummeting in uncertainty. Where are the job generators? Will corporations some office markets), hefty renewed concessions, mounting prop- continue to outsource jobs to overseas locations? How do we erty taxes, and inflated operating expenses. The only property factor in the nation’s looming deficits and perilous entangle- sector that hasn’t deteriorated is retail—kept afloat by con- ments in Iraq, Israel, and Korea? sumers flush with added buying power from refinanced mortgages and federal tax cuts. Grocery-anchored retail, fortress

3 “It’s hard to have much near-term conviction.”

Exhibit 1-1 Real Estate Firm Profitability Forecast Warehouses and apartments both suffer from uncharacteristically high, though still manageable, vacancies. But these sectors Prospects for Profitability in 2004 by Percent of Respondents usually rebound more quickly in economic turnarounds and are less exposed than office. For hotels, the key will be businesses’ Good 31% willingness to loosen their travel-budget pursestrings. Absent a surge in corporate profits and a decline in CFO nickel-and-dime Poor 1% accounting, that’s a questionable prospect. Modestly Poor 3% Excellent 4% Most developers, meanwhile, have been forced uncomfort- Very Good 21% ably to the sidelines. “We’re back to the early 1990s.” Although investors are relieved that recent construction has remained in

Fair 20% relative check and lenders appear to have been disciplined, “considerable overcapacity still exists in the markets. That’s another Modestly Good 21% way of saying we’re overbuilt.” Right now, “this country doesn’t need anything new for a while.” Surprisingly, the one unrestrained Source: Emerging Trends in Real Estate 2004 survey. sector has been apartments—lusty construction activity has continued even in the face of slackened demand. But investors continue malls, and power centers have fared particularly well, as to pay premiums for multifamily, expecting favorable demographics America’s passion for shopping continues unabated—for now. to propel future leasing and rent growth. For the most part, real estate investors, property companies, developers, and lenders are effectively adapting to this changing A Postponement Effect market, and a majority of Emerging Trends respondents are Of longer-term concern is the consequence of declining capi- expecting that the profitability of their firm will be good to talization rates propping up returns during an extended mar- excellent in 2004. (See Exhibit 1-1.) ket trough. The “unprecedented” anomaly of high prices and outsized returns in an otherwise troubled market could rob Facing Facts investors of any robust upside when properties move closer to At some point, reality sinks in. The heady elixir of seemingly low-as-you-can-go interest rates and ample inflows of capital, Exhibit 1-2 Returns: NCREIF vs. S&P 500 steering away from turbulent stock market, can’t camouflage property markets indefinitely—or offset declining revenues. NCREIF Some fallout is inevitable, and investors will need to refocus on S&P 500 replacement cost and exit risk, not just current returns based on 40% transient cash flows. 30% Challenges loom. In a general economic recovery, property

values could actually drop if interest rates surge before job 20% growth can boost leasing activity. Office markets always lag economic rebounds by as much as 12 to 18 months, and that 10% could mean big trouble in the current environment. Especially vulnerable are borrowers holding floating-rate debt; they’ll get 0% whipsawed if interest rates rise and net operating incomes drop further—or even stagger. “A lot of guys are just hanging on.” -10% There’s no doubt that office performance is headed for a rough -20% stretch. The survivors will be buildings with minimal tenant ´84 ´86 ´88 ´90 ´92 ´94 ´96 ´98 ´00 ´02´03 rollover and strong credit rosters to sustain rent levels above 2Q* market-rate declines. Sources: National Council of Real Estate Investment Fiduciaries, Standard & Poor’s. *Annualized figure.

4 supply/demand balance in 2006 and 2007. “Current returns Exhibit 1-3 Real Estate vs. Economy may be borrowing from future gains, making the next cycle very lackluster,” says a noted REIT stock manager. 20 GDP “It’s a postponement effect,” adds a leading researcher. Total NCREIF Instead of a more typical sharp decline during the cyclical 15 nadir, markets will clear “in a slow painful adjustment.” 10 “Pricing hasn’t corrected as you’d expect. Buyers have already anticipated a recovery in their cap rates, getting ahead 5 of current fundamentals. Future returns will focus mostly on property cash flows—you won’t see much appreciation. No 0 spikes like there were in the last cycle.” -5 As markets bump along toward an anemic recovery, 2004 will be a transition year. Cash flows will key performance. -10 ´83 ´86 ´89 ´92 ´95 ´98 ´01 ´03 Returns will be income driven. “It will all be about keeping up 2Q cash returns.” Buildings with solid tenant rent rolls will be fine. Sources: U.S. Department of Commerce, Economy.com, National Council Properties hobbled by declining cash flows will struggle unless of Real Estate Investment Fiduciaries. interest rates stay low. The bifurcation between “have” (tenants) *2003 GDP data are projected; 2003 NCREIF data are annualized. and “have not” properties will become more apparent. Downside risk clearly outweighs upside potential until the economy reignites—and that means substantial job growth. Got a Job? “You may wait a long time.” Expect moderate returns, with Economic expansion without significant employment gains is more distress and a few horror stories. Real estate will continue interviewees’ leading concern. “Job growth will be the key to to attract investors, but bad-news headlines may dim some of 2004. Period.” If corporations expand their U.S. workforces, its “safe haven” luster. vacant office buildings will begin to fill. Expanded production “It’s hard to have much near-term conviction.” and distribution will benefit warehouses, and increased business travel will buoy hotels. More wage earners—cashing bigger pay- checks—will rent more apartments and spend more in malls. That hasn’t been happening. The Economy: Concern Low interest rates and a flood of capital from investors flee- ing the equities’ tech wreck bought time for the property mar- about Job Growth kets, but any recent upticks in economic performance and cor- The dream for 2003—that the economy would rebound before porate earnings have come mostly through productivity gains— crummy real estate fundamentals could take their toll on at the expense of jobs. “Corporations have become very good at investors—has been painfully slow to materialize. The indus- doing more with less.” Since early 2001, when the recession try’s fortunes are inextricably tied to recovery. “Real estate is began, the United States has lost more jobs than at any time the tail of the dog. In the early 1990s, we were a drag on the since the Great Depression. Payroll jobs continued to be shed economy; this time it’s dragging us.” well into 2003, more than 18 months into supposed recovery, Emerging Trends interviewees are guardedly hopeful about and pay raises have been puny—only slightly ahead of inflation steady economic improvement in 2004. Nearly 90 percent expect and well below averages in the 1990s. “Companies have learned “low to medium growth.” Last year, close to 85 percent correctly to be lean,” says an interviewee, who works in a global money predicted “no to low growth.” While concern over a possible management firm. “It takes an act of Congress to get new peo- double-dip recession is negligible, none of our more than 200 ple in the door.” survey respondents predict high growth for the year ahead.

5 “The smartest people don’t know where rates are headed.”

Overseas Outsourcing—A Thorny Issue suffer as well. Today, it’s lower-paying service jobs that show the The jobless recovery has roots in technology advances and com- most growth; among corporate middle managers, unemploy- petitive pressures from globalization. Blue-collar jobs have been ment is well above average. Little surprise that Wal-Mart is now bleeding offshore for decades, going to countries where local the country’s top employer instead of GM or IBM. hires earn a pittance compared with what U.S. factory workers The potential real estate fallout isn’t all bad. Demand for earn. This leakage continues apace—more than 2 million U.S. affordable housing will escalate. And warehouse properties manufacturing jobs have been eliminated or moved overseas in shouldn’t be affected as much—once goods get shipped to the the past two years alone. Since the early 1990s, data processing United States they still need to be distributed. “That’s the other and call centers have also been successfully shifted to English- side of the global economy,” a researcher comments wryly. speaking countries like Ireland and the Philippines. A flare-up in India-Pakistan relations could stanch enthusiasm Now the trend is moving up the worker food chain, as for relocating operations to the Indian subcontinent. “There is knowledge-based tasks are transferred to lower-cost overseas something to be said for stability.” But lower-cost English-speaking sites as well. Analyst, research, accounting, and other white- alternatives abound worldwide. collar office jobs are ticketed to countries like India and China, which feature highly educated and motivated workforces earn- What Will Drive the Economy? ing fractions of comparable U.S. wages and benefits. “It was It might be extreme to call international outsourcing a “crisis” one thing to move a back office to the suburbs or send a call or “a deflationary nightmare” (our interviewees’ words), but at center to Sioux Falls—it’s quite another to move an accounting minimum the trend underscores the country’s growing struggle operation to Bangalore.” to find a new economic engine. “We need a saving grace, and Satellites, fiber optics, Web-based systems, and computing can’t assume we have a monopoly on creativity anymore.” The advances combine to make “a seamless operation” possible and big question: What will be the economy’s new driver? highly desirable for company bottom lines. “The Indian gov- “It’s hard to anticipate.” In the 1980s, insurance companies ernment rolls out the red carpet: you can pay MBAs less than and brokerages morphed into financial service giants while Ma $10,000 for work comparable to a U.S. job paying $50,000. Bell’s breakup fueled the telecom industry. High-tech stoked the Despite some extra costs for travel, relocation, and equipment, 1990s “and that turned out to be mostly b.s.” “Nobody seems to overall expenses can be cut by two-thirds.” know what will turn the trick now—it will be something.” The impacts of global white-collar outsourcing are unsettling Interviewees point to biotechnology and nanotechnology. at the very least. High-tech has been America’s recent edge, but Defense spending and homeland security offer more traditional, now industry behemoths Microsoft and IBM plan to move less cutting-edge wellsprings. But the tax-cutting wave and increasing numbers of high-paying software design jobs to Asia looming federal deficits limit government’s role in any jobs and India. Microsoft’s 5,000 planned new hires are welcome recovery. State and local governments, meanwhile, lay workers news, but 2,000 of them will be located outside the United off or freeze payrolls. States. In real estate, mortgage servicers have jumped on the The country’s advantages—wealth, strategic location, labor outsourcing-to-India bandwagon. By some estimates, U.S. com- mobility, huge markets, stability, rule of law, and educated panies will send upwards of 3 million service jobs overseas by workforce, among many others—outweigh current concerns 2015. “Do the math,” says one researcher. At 200 square feet and doubts about employment generators and global competi- per worker, “that’s 600 million square feet of office worker space tion. But clearly the solution isn’t more discount store sales- we won’t need.” Whatever the number, outsourcing means clerks or airport security guards. diminished growth in demand for office in the future. If U.S. corporate profits improve on the back of more belt- Interest Rates—A Slow Go tightening and global outsourcing, it may be good for share- Unquestionably, low interest rates have shielded both the econ- holders and stock prices, but not for U.S. job creation. Not omy and real estate markets: “They’re the difference between only will office expansions be constrained, but retail sales will now and ten years ago,” when property markets were mired in depression. Despite weakened cash flows, borrowers have “been

6 hanging on,” and delinquency and default rates have remained The Housing Market and Consumer low. Low-cost debt on well-leased properties has boosted Credit—Keep Your Fingers Crossed returns. Put another way, “low interest rates have covered up Although Emerging Trends doesn’t attempt to forecast single-family industry flaws and made up for some bad underwriting.” residential markets, it’s clear that a decline in house prices would Most interviewees expect and hope that rates will climb threaten the economy—upending consumer spending and knock- slowly in 2004, coaxed along by the Federal Reserve as the ing out a key driver in recovery. “It could be the biggest threat.” economy strengthens. “It’s an educated bet that the Fed won’t The American consumer has been overextended for years on credit raise rates dramatically in an election year and will try to care- card and mortgage debt, spending through the recession on the fully manage the recovery.” back of inflating home equity. Low interest rates have spurred a tsunami of homeowner refinancing that feeds consumer purchases Exhibit 1-4 “Prime” Lending Rate at malls and car dealerships. Lower mortgage payments mean more cash to burn.

25% More important, low mortgage rates have enabled many first-time home purchases and trade-ups, strengthening home prices and property values. If housing demand drops because 20% higher interest rates make mortgages less attractive, and home values consequently ebb or fall, retail’s recent run-up could be 15% over. And if consumers stop spending, any rebound in corporate profits would hit the skids. Bad news for everyone. But

10% realistically, if the housing market is not another bubble, it’s at least due for a breather. Multifamily owners see a silver lining in the prospect of 5% higher mortgage rates: fewer homebuyers will mean more apartment renters. However, an improved business environ- 0% ment and resumption of job formation are more critical to ´80 ´82 ´84 ´86 ´88 ´90 ´92 ´94 ´96 ´98 ´00 ´02 ´03 2Q feeding the renter pool. Source: Federal Reserve Board. Ample Dollars: Capital Pulls Stable or declining rates would mean only trouble at this Back, Not Out point in the cycle—the economy isn’t gaining any traction. But Real estate’s risk profile has improved over the past decade. if interest rates rise too quickly before supply/demand trends Heightened regulatory scrutiny, greater transparency, more pro- improve, floating-rate borrowers will suffer shortfalls and values fessional analysis, and public market oversight give investors could decline. “A 200-basis-point increase in interest rates increased confidence in their ability to assess holdings. Recent pushes up cap rates while NOI [net operating income] doesn’t solid returns have reinforced perceptions that real estate yields go anywhere,” observes a pension fund adviser. “That’s the can be sustained through entire cycles, including market troughs. biggest risk. The next 18 months are problematic.” But interviewees are concerned about whether the recent If interest rates ratchet up suddenly from some exogenous surge of capital into the property markets and the ensuing cap shock, “a lot of people could be cooked.” Concern mounts over rate compression reflect a more permanent shift in real estate’s the federal deficit and increased government borrowing, which standing or a temporary cyclical phenomenon driven by equity normally exert upward pressure on rates. The country’s current- outflows from the 2000–2002 bear market on Wall Street. accounts deficit and burgeoning expenses in Iraq cloud the outlook further. “The smartest people don’t know where rates are headed.”

7 “Real estate may turn out to be a flavor of the month if the stock market gets hot.”

Coming out of the early-1990s debacle, cap rates shot up as Exhibit 1-6 Asset Class Investment Potential investors factored more risk into the property sectors. During for 2004 the late 1990s, as property markets returned to equilibrium, “cap rates stayed high when the risk premium should have been 10 shrinking.” With the risk profile declining, investors have been Scale: 0 to 10 (poor to excellent). willing to take lower returns in stronger property types (apart- 8 ments, warehouse, neighborhood shopping centers, well-leased

downtown office) with minimal leasing risk. “On balance, cap 6 rates should stay lower for these stronger property types,” says a researcher. In fact, cap rates actually trend near historical aver- 4 ages despite recent compression. (See Exhibit 1-5.)

2 Exhibit 1-5 NCREIF Cap Rates

10.0% 0 Domestic Investment High-Yield Real Estate Real Estate Money Global International Stocks Grade Bonds (private) (public) Market Investments RE Stocks 9.5% Bonds Funds

9.0% Source: Emerging Trends in Real Estate 2004 survey.

8.5%

8.0% Exhibit 1-7 Spreads Between ACLI Cap Rates Historical Average 7.5% 7.97% and Ten-Year Treasuries

7.0% 550

6.5% 425 6.0% ´79 ´80 ´82 ´84 ´86 ´88 ´90 ´92 ´94 ´96 ´98 ´00 ´02 ´03 2Q 300 Sources: National Council of Real Estate Investment Fiduciaries, PricewaterhouseCoopers. 210 average (1970–2003) Note: Quarterly moving average. 175

50 Private syndication activity and increased pension fund allocations support the view that capital flows are broadening, and -75 the maturing CMBS and REIT sectors have secured real estate’s position in the public markets. “Real estate will never be a -200 ´70 ´72 ´74 ´76 ´78 ´80 ´82 ´84 ´86 ´88 ´90 ´92 ´94 ´96 ´98 ´00 ´02´03 rock-star asset class,” says an interviewee, “but investors, partic- 2Q ularly baby boomers, want the attractive yields real estate offers, Sources: American Council of Life Insurers, Federal Reserve Board, PricewaterhouseCoopers, Economy.com. and that will keep money flowing and cap rates down.” Most respondents believe an improving stock market will Note: 2003 figures as of July 2003. siphon capital from new property investments, and 2004 may prove the point. For the first time in four years, a majority of But more than 95 percent of the interviewees forecast that Emerging Trends respondents (52 percent) predict that stocks will real estate will beat bond returns, and the persisting cap rate outperform real estate and that investment potential for both spread of over 400 basis points between real estate yields and private and public real estate will diminish. ten-year Treasuries continues to offer real estate investors com- “Real estate may turn out to be a flavor of the month if the fort with respect to risk-adjusted performance. (See Exhibit 1-7.) stock market gets hot.” Still, as a pension fund adviser points out: “Investors are fickle. Real estate isn’t big enough to accept all the money that

8 has wanted to come in lately. It’s an alternative investment cate- chill investor appetites for properties in general. With soft ten- gory, not an asset class like stocks and bonds. If the stock mar- ant rosters and uncertainty about the depth of vacancies, there’s ket looks good, money will move out.” scant reason for near-term comfort. Barring an unlikely rash of bad headlines and red ink, any pullback will be confined to momentum investors. Premium pricing will dissipate, and underwriting will become more discriminating. Office could suffer from weakening operations, and retail Intensifying Unease over has been overheated. Other sectors should hold their own. “Real an Uncertain World estate delivered on its promise—it stayed in positive territory and offered diversification. It’s done its job. We’ll cruise along.” Since the late 1990s, real estate’s durability and resistance to a host of shocks and troubling undercurrents have impressed investors, A “Ton” of Vacant Office Space drawing new adherents. Fallout from 9/11 dampened hotels and shook confidence in office towers, but overall impacts have been Despite all the credible evidence of greater transparency and restrained. The Enron and WorldCom scandals in 2002 raised information flow in the real estate markets, most analysts admit questions about credit tenancy, but were otherwise nonevents for a lack of certitude in calculating levels of current office vacancy. property investors unless fallen companies were their tenants. They use words like “massive,” “unprecedented,” “as bad as ten years ago or worse.” Brokerage firms put out their leasing reports, but the numbers don’t convince anyone. “We’re proba- Wavering Confidence bly identifying 80 to 90 percent” of the vacancy, said one ten- In general, the longer-term nature of mortgages and leases has ant representative. “But it’s very hard to pin down.” helped insulate real estate investments from volatile shifts and Getting a handle on the extent of phantom (empty occu- damaging swings during choppy periods. Eventually, real estate pied) space, in addition to ample sublease vacancy, has been the reflects general economic conditions, but it typically lags primary conundrum. Corporate business units have held onto behind both good and bad phases, smoothing out dips and unused space, anticipating new hiring. Languishing cubes seem humps along the way. Today’s uncertainty about geopolitical omnipresent. “Companies aren’t going out of their way to risk, however, is gnawing away at confidence levels and eco- report subvacancy and shadow space.” Once they start expand- nomic underpinnings, raising concerns among interviewees ing again, they won’t need to lease new space immediately. about the strength of any real estate rebound. In addition to Then there’s the totally vacant but still-leased space, which the global competitive forces pressuring the U.S. economy, a creeps off rent rolls. “The pain continues to shift from tenants to host of world conflicts test our security and well-being: landlords” as this space burns off, depressing net operating incomes. ■ Israeli/Palestinian turmoil spirals out of control, destabilizing Most observers predict there won’t be any significant office the entire Middle East. leasing upswings until 2005, and rents won’t increase until mar- ■ Iraq looks like a sump for U.S. tax dollars as we attempt to kets show some signs of returning to equilibrium. How long establish social order in the face of terrorist resistance and local that takes depends on how much vacant space is really out distrust. Afghanistan remains a hot spot, and next door, Islamic there, and the velocity of job growth. Rental rates in many Pakistan retains nuclear weapons as its shaky government par- markets have fallen to mid-1990s levels or lower—well below ries threats with nuclear neighbor India. peaks of the late 1990s and in the range of mid-1980s rents in ■ North Korea’s growing nuclear arsenal menaces Asian security, some markets. “When five- and seven-year leases come due, confounding Pentagon planners. tenants should be able to sign sweet deals. Many will be able to Countries from Africa through the Asian subcontinent, the trade up to higher-quality space for less. That spells big trouble Pacific, and South America represent potential breeding grounds for lower-quality office space, some of which was rescued from for anti-Western terrorists, who seem able to strike anywhere at obsolescence by the tech-bubble leasing boom. any time, but probably can’t and won’t. Perceptions of office-market health typically influence feel- “These world events are sidetracking us—creating uncer- ings about real estate’s overall investment potential. Skylines tainty and putting drags on our economy,” says an interviewee. and towers showcase the property markets’ most visible calling “Decisions important to real estate are outside one’s control. It’s cards—too many see-through floors and “For Rent” signs can more difficult to assess risks and plan accordingly.”

9 Only a marginal lowering of concern about terrorism’s negative impact on real estate reg

Terror Redux Skyscraper Anxiety Except for the very tallest buildings in The domestic terror threat has been pushed toward the back- major 24-hour markets like New York and Chicago, fears about ground. “Time has helped us come to terms. We’ve bounced occupying skyscrapers appear muted. But tenant skittishness back from the first one.” But last year’s overriding interviewee has compromised the value of a handful of icon skyscrapers. assumption holds firm: another disruptive strike will occur “People are still worried about being on the 80th floor.” somewhere, sometime, and perhaps with considerable conse- quences. Only a marginal lowering of concern about terrorism’s Dispersion Major companies continue to disperse operations, negative impact on real estate registers in this year’s survey (see both within major metropolitan areas and to geographically Exhibits 1-8 and 1-9). Here are 9/11’s lasting repercussions: diverse locations. “All the big New York–based financial companies are moving operations outside the city. They’ll keep a headquarters presence and certain functions, but not everything in Exhibit 1-8 Negative Impact of Terrorism on Real Estate one central location. It’s too risky.” Memories of 9/11 only re- inforce companies’ inclinations to seek lower-cost space outside 100% 95.3% 93.6% 95.0% 86.5% premium office markets wherever possible, whether domestically 78.7% or internationally. 80% 69.5% 65.1% Insurance As expected, the market has resolved most insur- 60% ance cost–related issues stemming from the World Trade Center

40% attack. Owners absorb added, but not dramatically higher, costs for most properties. But the federal government backstop sun- 20% sets at the end of 2005, which could revive the issue.

0% Security and Safety Expenses Wherever possible, build- CBD Suburban Regional Industrial Garden High-Rise Full- Office Office Malls Warehouse Apts. Apts. Service ing owners have shied away from shelling out for top-of-the- Hotels line security systems, though installation of additional guards Source: Emerging Trends in Real Estate 2004 survey (percentage of respondents). and cameras has increased costs modestly at some properties. More prominent buildings with Fortune 500 tenants in major markets typically maintain greater vigilance, employing not Exhibit 1-9 Impact of Terrorism on Skyscrapers only typical rent-a-guard ID screening, but also expensive opti- cal badge-reading turnstiles and/or metal detectors. Most tenants in most places are considerably more concerned about Some petty theft than a terrorist assault. They don’t want to go 73.6% through the hassle of checkpoint screenings, let alone pay addi- None tional pass-through charges. Outside major markets or in more 5.7% commodity-type buildings “it’s walk right in and get in the ele-

Significant vator, just like it’s always been.” 20.7% Mall Vulnerability Throughout the world, terrorists have historically targeted shopping districts, where they can wreak havoc anonymously and escape detection. Although the Oklahoma City and 9/11 attacks struck office buildings, inter- Source: Emerging Trends in Real Estate 2004 survey. viewees continue to be more concerned about malls or other shopping centers. These properties are largely defenseless and the lasting damage to consumer psyches could be severe.

10 egisters in this year’s survey.

Travel Woes Terror alerts fray nerves. International flare-ups Outsourcing Enabler Telecom, Web, and satellite systems keep people closer to home. And tighter U.S. visa restrictions are the great enablers of the burgeoning wave of outsourcing. reduce foreign visitations. All spell less business for many hotel Increased use of hoteling and work-from-home consultants nib- operators. First, the World Trade Center tragedy devastated occu- bles at office space requirements—they just beam in their work. pancies and revenues; then foreboding over the war in Iraq delayed WiFi makes office layouts more flexible and slims down space any recovery. Who knows what’s next? That’s the problem. per capita at the margins.

Web Merchants Gain Footholds In steady increments, more people are shopping on the Internet. Web sales surged 50 Technology Bites percent in 2002 and could amount to more than 4 percent of For all the talk of tech wreck, one would think we’d returned total 2003 retail sales if some estimates hold up. A majority of to the Dark Ages. To the contrary, technology’s impact on real Webtailers have turned profitable. Still in its infancy, e-tailing estate continues to evolve—reducing the need for space and will steadily bite into the market share of brick-and-mortar cutting demand growth in a number of ways. retailing. Eventually, online and offline merchandizing will become more integrated, reducing the need for store space. It’s How Increased Use of Technology by just a matter of time. Exhibit 1-10 Business and Consumers Affects Warehouse Scanning Nowadays shippers are attaching Demand for Real Estate radio frequency ID chips to pallets, tracking them to their des-

By Percent of Respondents tinations with global positioning satellites and more closely matching delivery needs to inventory requirements. It’s the lat- 100% est wrinkle for just-in-time distribution systems, which have steadily reduced the need for warehouse storage over the past 80% 15 years.

60% Hotel Woes Internet pricing power slashes at hotel earnings. Surfers have learned to shop for last-minute bargains and get them as operators compete to fill empty rooms. Information is 40% power, and the Web gives travelers an advantage in searching out deals. 20%

0% Hotel Office Retail Industrial Apartment

Increases Has No Decreases Demand Effect Demand

Source: Emerging Trends in Real Estate 2004 survey.

11 Investment Trends chapter 2

“Most Emerging Trends interviewees envision 2004 as a transition year.” 2004

eal estate markets stabilize, then slowly strengthen behind a reviving economy. There’s no sudden Time for a R rebound—rents are flat in most sectors, down further for office. Income returns carry the day. Appreciation is negligi- Reality Check ble, and many office markets experience value dips or worse. The market needs to better scrutinize the “in-betweeners”— Retail returns moderate off recent highs. Warehouses, apart- B-quality buildings in lesser locations where zealous buyers ments, and hotels improve slightly. Capital flows remain plenti- have been overlooking leasing risk and factoring excessively ful, but diminish as an improving stock market draws atten- optimistic recovery scenarios into their buy assumptions. “Cap tion. Defaults and delinquencies increase modestly—again rates have been distorted by leverage, and people are overpay- office markets suffer most. ing.” These investments have been unrealistically “priced for As investors grow more discerning, market bifurcation perfection.” Expect ardor to wane without downward pricing increases. Demand stays focused on trophy office and fortress adjustments for these properties. mall properties (the few available) and on the “cash-flow In general, 2004 will be a better year to sell than to buy. kings”—warehouses, apartments, and grocery-anchored retail. (See Exhibit 2-1.) Yields have been acceptable, but frothy pric- But “a huge gulf opens between the very best and everything ing levels limit any upside potential for acquirers. “It’s treacher- else.” Buildings with vacancy issues go begging unless owners ous; you’re basically buying bonds.” Another interviewee dead- capitulate on pricing (which some may do if interest rates track pans: “It’s tough to make an acquisition without feeling it up) and finally register their large value writedowns. might be your next writedown.” Quality deals have been “few and far between.”

13 The investment banks continue to shift their attention to raising money for core vehicles.

Exhibit 2-1 Emerging Trends Barometer: 2004 money, meanwhile, pushes down overall yields. Without market volatility and dislocation, the environment is radically dif- Buy/sell/hold rating prospects on a 0-to-10 (poor-to-excellent) scale. ferent from the last cyclical bottom in 1993–1994, when own-

6.5 ers were bailing out in a liquidity crisis. “Back then it was ele- 6.1 phant hunting,” says the portfolio manager of an opportunity 5.2 fund. “Now you’re shooting squirrels and chipmunks.” Opportunity funds have been scrounging for “needles in the haystack,” venturing outside the major property sector groups to look at land, apartment condominium conversions, even golf courses. Other opportunity funds have masqueraded into core- plus plays, using spread investing (positive leverage) techniques. Return-rate expectations have realistically declined from the 20- Buy Hold Sell to-30-plus range into the mid to high teens, still using those large dollops of leverage. “Our returns look good against T- Source: Emerging Trends in Real Estate 2004 survey. bills,” says a fund manager. But then, leveraged core investing certainly looks like the better risk-adjusted gambit. Considerable capital sits on the sidelines—waiting, wishing, Until capital pulls back, sell into the wave, save your profits, and hoping for owners to throw in the towel before a recovery and look for better opportunities when distress increases. takes hold to bail them out. If surrender occurs, large dollar flows During the year, sellers will adjust their expectations downward could dampen opportunistic yields. “That’s what’s happened with and purchasers will become more realistic—paying attention to B malls, where sellers have been achieving decent pricing.” the shaky supply/demand fundamentals. Until then, “it’s easier Some of the opportunity funds that invested through the to stay away from things.” Holders of well-leased properties late 1990s and into the market trough may be suffering. Once- “with credit and term” have the right idea: “Where else can juicy development deals in high-tech markets are floundering. [they] get better returns?” Leveraging strategies are no-brainers— Empty buildings or half-built projects devour investor equity. but avoid floating-rate debt. Brokers will lament the overall Market-peak rental assumptions have gone sideways or worse, slowdown in transaction activity. and re-leasing strategies have been stymied. Some assets are illiquid and overleveraged. Ironically, opportunity fund investments are turning into opportunities for others. The investment banks continue to shift their attention to Core Dominates raising money for core vehicles. Does that tell you anything? Opportunistic “Consolidation is coming for opportunity funds.” Buyers have been willing to pay premiums for anything that is stable and leased. “It’s the era of surety of income and aversion to volatility: everyone’s moving to apartments, industrial, fortress malls, and neighborhood centers.” Compromised properties exist, but owners have not been pushed to sell. Most can meet their mortgage costs, thanks to low interest rates—and buyers want vulture pricing or nothing. A deluge of core

14 Does that tell you anything? “Consolidation is coming for opportunity funds.”

Best Bets 2004 Sell into “hordes of cash.” Borrow now. Sell now, before overzealous capital figures out that it has been too Use leverage (up to 65 percent) to enhance yields on core apart- generous. The window is closing. In particular, unload core office ments, warehouse, and retail. “It’s today’s best opportunistic- with near-term rollovers—it has more downside risk than oriented return.” Be sure to lock in mortgage rates (ten-year upside potential. Rent growth will be terms). They’re expected to increase unless the economy tempered during the next up- double-dips—which is an unexpected scenario. cycle unless job formation gears up unexpectedly. Any- Be patient and husband thing with near- to medium- resources. term tenant turnover will face “Distress will unfold during the year.” Weak industry funda- prospects for declining revenues mentals will lead to some chances for opportunistic buying. as late-1990s leases begin to burn As owners are forced to say uncle and submit to bargain off. Expenses are up and conces- hunters, more hotels, suburban office—even some apartments sions are back. Time to exit. and industrials—will hit the sales block. Focus on hard-hit tech-wreck office markets like San Jose, Boston suburbs, and Buy credit and Austin. Price assets at current rents, not contract rents, and term office. avoid paying for structural vacancy. Underwrite for three- to Avoid rollovers (in the next five years five-year recovery scenarios. Move quickly: the window is or longer) and load up on low-cost narrow and the vultures are lined up to pounce. Cheap deals fixed-term debt. “Even if you over- may get bid up fast. pay today in Washington, D.C., or New York, it’ll look like a good Identify vanguard markets investment in ten years.” Returns that will lead the recovery. can easily ratchet up into the low Most interviewees choose diversified markets with defense teens, with little risk, on these “credit industry components. Nation-building efforts and terrorist and term” gems. “You’re buying enough time to let the mar- episodes will fire up military and homeland security–related kets recover.” These properties are worth the premiums, but there businesses. San Diego and Orange County should benefit, and aren’t many on the block. Holding on makes sense, too: current own- D.C. suburbs are also prime candidates. California’s deficit crisis ers would have trouble bettering returns on their proceeds. could spell opportunity for Portland, Seattle, Las Vegas, and Phoenix. A California exodus could also benefit Colorado mar- “Dare to be boring.” kets, as businesses and individuals (especially from northern Buy industrials. Warehouse properties react more quickly to California) flee higher taxes and costs of living. economic upswings. Don’t expect any steals, but cash flows are attractive—“rents haven’t been clobbered” despite high vacancies. Concentrate on the leading distribution hubs.

15 Bide your time on apartments. Sell malls and power centers. Buy only when mortgage rates start to increase with conviction, “Retail values are too high and returns don’t make sense after and focus on markets with barriers to entry, typically coastal calculating capex [capital expenditures].” Fortress malls and the metropolitan areas. Voracious demand from institutions and better power centers are keepers. private investors provides an attractive exit for sellers at seemingly low-as-you-can-go cap rates. Consider buying full-service hotels. The worst is over. After 9/11, SARS, Iraq, what else can hap- Expect REITs to trade pen? Come to think of it, don’t ask! Despite all the heartaches, in a narrow range. owners have been hanging tough—bottom-fishers have been Earnings could be flat or down. But good yields will remain disappointed in the dearth of deals. But it may be a compelling attractive. There’s more chance for downside than upside. play if business travel starts to accelerate. Most vulnerable are office (rents are declining) and retail (due for a selloff). Examine second-tier markets. Institutions have avoided most backwaters. Competition for Prune grocery-anchored retail. deals is less frenzied and pricing is more realistic. But markets Centers with less than top-tier supermarkets are threatened by are extremely shallow. Focus on the very best properties in the expanding discounter superstores. Pricing has been out of con- best locations. trol. “The sector is overrated” after a great run. Sell into the demand curve, but retain prime infill locations. Look at affordable housing—both development and redevelopment. Undersupply continues and demand rises, especially in major cities and affluent suburbs where the divide between rich and poor is widening and service jobs are abundant.

Develop/redevelop warm-weather, waterfront condominiums and mountain resort hideaways. “Incredible” demand surges from affluent baby boomers pre- paring for retirement and looking for dream second homes. Florida boasts some prime opportunities: aging, low-rise, first- generation beachside apartments can be converted into high rises. Rocky Mountain states offer different but no less attractive lifestyles.

Focus on infill redevelopment. Traffic congestion and sprawl encourage “the move back in.” Underutilized, inner-suburban-ring retail is ripe for mixed-use

Photo Courtesy of Development Design Group, Inc. makeovers, including large residential components. Main Street concepts based on new urbanist planning can resurrect dead malls and provide a shot in the arm to struggling communities.

16 Office tenants, upgrade! If lease renewals are imminent, take advantage of soft office mar- Caution! kets and relocate to better buildings and locations at lower cost, Take greater care in evaluating below- nailing down rates for as long as possible. Concessions are ample. investment-grade CMBS offerings. Landlords will cut deals to secure income. Strike while you can. Issuers sell bonds into market demand, “but relative value is not there.” Underwriting has slipped as markets weaken—not a good combination. “Worry about deals with suburban office.”

Steer clear of syndications. The 15 percent front-end loads put investors in an immediate hole, and fee-driven asset purchases are forced in markets with flimsy fundamentals. If sponsors are leveraging up returns on mediocre properties, watch out for additional trouble down the road. Investors may not lose money, but returns could fall short of expectations. “Why invest in syndications when you can buy real estate mutual funds with higher yields, diversification, and a much lower-cost fee structure—there’s no rationale.”

Avoid! Shun almost all development (it’s too early); commodity properties—especially plain vanilla suburban office (the real pain is only beginning); and seniors’ housing (a concerted demand wave is still ten years away).

17 Real chapter 3

“Liquidity won’t go away—it will just be reduced.”

Estate Capital Flows hen real estate tanked in the early 1990s, capital investor fervor, while low mortgage rates help boost payouts gridlock strangled the markets, forcing widespread and “offset high pricing.” But at some point, supply/demand Wforeclosures, bankruptcies, and workouts. Today, realities and sagging revenues will catch up with performance apartment markets are more overbuilt than they were back and capital flows will readjust accordingly. “Real estate has been then, warehouse vacancies have never been higher, and office overachieving its fundamentals.” occupancies tumble toward decade-old lows. Yet monies flow The recent absence of buyer interest in battered suburban freely into real estate and mortgage investments. Despite obvi- office and R&D, except at bargain basement pricing, suggests ous property weaknesses, a profusion of capital has buttressed that capital is still able to find its bearings. “Capital hasn’t been values and returns. dumb—development has been kept under control. But investors The reason: a decade of excellent performance—spanning have been paying up for secure income streams.” It would be an entire real estate cycle—has restored investor confidence in unrealistic for spigots to stay wide open unless there’s a sudden, the property markets. More recently, interest-rate manna in the unexpected economic leap. And, if you haven’t noticed, the stock form of healthy spreads between real estate yields and T-bill market has revived—not enough to convince a tide of Main returns and an unprecedented Wall Street bear have kept dollars Street investors to return en masse to Wall Street, but enough to cascading, even in the market trough. Income from favorable take the edge off real estate’s safe-haven, “place to be” aura. lease structures and seductive risk-adjusted returns buoy

19 Whether markets are good, bad, or mediocre, there is more capital available for real

In 2004, investors will turn more cautious and selective about Exhibit 3-2 Availability of Capital 2004 property deal making, especially if job growth falls short and rental rates decline further. Make no mistake: the flows will be plentiful enough, particularly for sought-after sectors—warehouses, apart- Private Investors 7.2 ments, “credit and term” office, and top-tier retail. And if a recov- CMBS 7.1 ery takes root, “a bundle of money looks for an entry point.” Emerging Trends respondents appear confident about an abun- Pension Funds 7.0 dance of capital from all sources. (See Exhibits 3-1 and 3-2.) Entrepreneurial Capital 7.0

Commercial Banks 6.7 Exhibit 3-1 Real Estate Capital Market Balance Forecast Life Insurance Companies 6.6

Balance of Capital Supply and Demand in 2004. Wall Street 6.6

Foreign Investors 6.4

REITs 5.9

Overall 7.1 0 5 10 15.3% In Balance 55.9% Moderately Oversupplied Decrease Stable Increase

6.2% Moderately Undersupplied 22.5% Substantially Oversupplied Source: Emerging Trends in Real Estate 2004 survey.

Source: Emerging Trends in Real Estate 2004 survey. Although near-term performance could be humdrum, there is an overwhelming consensus among respondents that real The interviewees have good reason to believe that flows will estate returns will remain solidly in the black. Delinquencies hold at sufficient levels to ensure reasonable liquidity. Whether and workouts will likely increase, but not to alarming degrees. markets are good, bad, or mediocre, there is more capital avail- “It doesn’t look like we’re going to blow it this time.” In short, able for real estate than ever before. Since the early-1990s capital has no reason to be scared off—but it should become depression and ensuing cash-crunch debacle, the industry has more discriminating and realistic. developed vast new sources. Most significant, substantial new public debt (CMBS) and equity (REIT) markets now link commercial real estate to huge global capital pools. More Capital Trends: Equity recently, the private syndication market has been resurrected as Institutional capital will become even more discerning in 2004, a significant force in U.S. equity markets. Pension funds’ confi- and syndicator activity will abate after a frothy run. Ample dol- dence in equity investments has been restored and their interest lars from pension funds and opportunity investors are ready to in CMBS is growing. Fund allocation targets have been raised. flow, if owners are motivated by balance sheet shortfalls into a Foreign investors remain active players and life insurers contin- disposition mode. Meanwhile, heightened pension allocations ue as important lenders in the mortgage markets. Wall Street undergird REIT capitalizations. Equity sources aren’t backing investment banks step up their presence, and commercial banks away from real estate, but buyers are increasingly reluctant to are bedrock mortgagees. overpay—they’re focusing more on finding relative bargains in struggling markets.

20 estate than ever before.

Syndicators potential bad press about declining office markets may spook the moms and pops. In any case, momentum investors are like- Crowding Out Institutions Like a phoenix, private syn- ly to back off “when the next best thing comes along” or the dication has emerged as a dominant force in the equity mar- stock market sustains advances. kets, driving office and apartment prices to what many consider “unrealistic” highs. Most interviewees “scratch their heads” and wonder whether syndicators can sustain capital raising that REITs depends on “country club money” looking for stock market Dependence on Dividends While syndicators have driven alternatives. Or is this epic spending spree just another round the acquisition markets, real estate investment trusts have been of Sisyphian overreaching, doomed to come crashing down net sellers, opportunistically pruning portfolios “and cleaning when investors eventually count their “disappointing” returns? things up.” “REITs have been playing it smart,” says a stock “Syndicators are the chink in the real estate story,” wails an manager. “They’re focused on making money for shareholders, institutional investor, recalling the debacle following the tax not making fees on the front end like the syndicators or accu- syndication wave in the early 1980s. “Between the financial mulating assets like pension advisers.” planners and the sponsors, they take a 15 percent promote off REIT prices already anticipate a “very good real estate the top. Then they bid up prices in auctions, putting their recovery,” but dividends “appear safe” and most companies are investors deeper in the hole. Grandma and Grandpa don’t well capitalized. “Earnings could be mediocre in 2004 and know better. If the sponsor uses leverage, it gets worse. How 2005.” This prediction by an office REIT executive is echoed does the math make sense?” by an apartment company CEO: “Earnings will stabilize” and Adds a Wall Street pro who knows the drill: “It could be a REITs will trade “in a narrow range.” Regional mall and strip recipe for disaster—raising so much money with pressures to center REITs have enjoyed an extraordinary run, but observers get dollars out in weak markets and earn acquisition fees.” anticipate “sector rotation” out of retail. “A technical recovery ahead of fundamentals has already been figured into those Disappointing Returns? Syndicators counter that some of stocks—it doesn’t take a genius to know that grocery-anchored the criticism is sour grapes over lost deals; they insist that prop- retail is overvalued.” A capital markets expert agrees: “Apart- erties have been underwritten off reasonable cash flow models. ments and industrial REITs are a better value than overpriced Office properties with long-term leases have been purchased, retail, but office appears in for tough sledding.” and apartment acquisitions should benefit from future demographics. Income streams are relatively secure, returning 6 or 7 percent dividends annually, and investors own hard assets so they won’t get wiped out. These investments are countercyclical to stocks and bonds, provide a “safe” return, and “look good compared with the alternatives.” But no one claims much upside potential from appreciation. Individual investors provide a cheaper cost of capital: “They’re not like pension funds, benchmarking returns off the NCREIF index,” says an interviewee. The consensus view suggests that most syndicator investments “won’t blow up,” but returns will be “average to below average.” Reversion risk exists and investors may have trouble getting their money out when they want it. “Syndicator clones are coming out of the woodwork,” and the big investment banks ramp up new core investment vehicles to tap into the retail real estate demand while they can. Syndicator scorecards may take years to evaluate, so near-term investor results should not affect investment flows, although Tim Hursley photographer.Tim Courtesy of Kohn Pedersen Fox and Gannett/USA Today.

21 In 2003, REITs gained uncontested dominance among institutional capital sources

Capital Sources and Flows

Exhibit 3-3 Real Estate Capital Flows

200

REITs 150 Pension Funds

Foreign Investors 100 Equity ($ Billions) Life Insurance Companies 50 Savings Associations

Commercial Banks 0 ´88 ´89 ´90 ´91 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ´01 ´02 ´03 2Q

1,000 Commercial Banks

Nongovernment CMBS 800 and ABS Issuers

Foreign Investors 600

Life Insurance Companies 400 Debt ($ Billions) Savings Associations

200 Federally Funded Mortgage Pools

0 Other ´88 ´89 ´90 ´91 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ´01 ´02 ´03 2Q

An investor surge into real estate securities and a related sharp ance companies’ (7.8 percent) shares held relatively steady. Private increase in stock prices during the second quarter of 2003 propel syndicator shares are difficult to track and show up in the noninstitu- REITs to uncontested dominance among institutional capital sources tional category. for equity real estate. REITs now control a record 46.6 percent of total Institutional debt vaults over the $2 trillion mark for the first time, rep- equity investments, up from 42.5 percent in Emerging Trends in Real resenting nearly five times the total equity invested by institutions in the Estate 2003. The other equity kingpin, pension funds, lost further property markets. All major lending sources, led by commercial banks, ground from 37 percent to 33 percent despite talk of raising allocation increased their debt origination volumes as low interest rates inspired a targets. Most plan sponsors were unwilling to go head to head with private financing and refinancing boom among property owners. CMBS issuers’ syndicators in bidding up acquisition prices, and some funds preferred share leveled off during the year after more than tripling since 1997. instead to invest directly in REITs, pushing up the securities’ share of the Foreign banks and insurers continue to be major players, but their activity capital pie. Back in the pack, foreign investors’ (11.9 percent) and insur- pales in comparison to that of commercial banks and CMBS.

22 for equity real estate.

Exhibit 3-4 Institutional Capital Sources

Institutional: $2,471.64 Billion Total U.S. Real Estate: $4,715.60 Billion

Noninstitutional: $2,243.96 Billion

Savings Associations $0.9 Billion–0.2% Commercial Banks $2.6 Billion–0.6% REITs Life Insurance Companies Institutional $197.2 Billion–46.6% Total Equity: $423 Billion $32.9 Billion–7.8% Foreign Investors $50.3 Billion–11.9%

Pension Funds $139.1 Billion–32.9%

Savings Associations Federally Funded Mortgage Pools $180.1 Billion–8.8% $98.9 Billion–4.8% Institutional Foreign Investors Other Total Debt: $2,048.6 Billion $243.6 Billion–11.9% $53.2 Billion–2.6% Pension Funds Life Insurance Companies $27.2 Billion–1.3% $234.6 Billion–11.5% REITs Nongovernment CMBS Issuers $8.3 Billion–0.4% $330.1 Billion–16.1% Commercial Banks $872.6 Billion–42.6% Sources: Money Market Directory, NAREIT, FDIC, ACLI, BEA, Federal Reserve, Lend Lease Real Estate Investments, and Rosen Consulting Group.

23 If syndicator activity decelerates, pension funds are positioned to pick up some of the

Cap 400, Small Cap 600, and Russell indexes has earned addi- Exhibit 3-5 Equity Real Estate Performance vs. REITs tional credibility for the property markets. But governance headaches and the high costs of running 40 NAREIT public companies may deter new REIT entrants. “There’s enough liquidity in the capital markets, where you don’t need NCREIF 30 to go public.” Developers and entrepreneurial players find themselves hamstrung by quarterly reporting. “It’s too capital- 20 intensive a business—it’s hard to post consistent enough returns to sustain shareholder support, and in a down cycle you get 10 murdered.” Requirements to pay out earnings in dividends can handcuff company growth strategies. Some REIT executives 0 complain that they want to move into less passive structures like c-corps, where they can be more opportunistic. In addition: -10 “Expect continuing consolidation as some smaller firms determine the public markets just aren’t for them and merge into -20 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ´01 ´02 ´03 larger competitors.” The big will get bigger. 2Q REITs’ overall market share will expand slowly over the next Sources: National Council of Real Estate Investment Fiduciaries (NCREIF) and National Association of Real Estate Investment Trusts (NAREIT). decade, but the high-octane growth spurt of the mid-1990s Note: NCREIF 2003 data are annualized from first two quarters. “won’t return.” Private markets will orient to greater risk-taking NAREIT 2003 figure is annual return from second-quarter 2002 through and entrepreneurial endeavors, while public companies concen- second-quarter 2003. trate ownership stakes in office, neighborhood retail, apartments, and warehouses—the income flow and dividend drivers. A strong minority view warns that REITs’ “exceptionally Large REITs will absorb the holdings of some real estate fami- good” four-year run (versus the S&P 500) and prices “ahead of lies and private-market patriarchs who have succession and fundamentals” signal vulnerability and an overall REIT market inheritance issues. “There’s a lot of dialoguing going on.” correction. “They can no longer be touted as growth stocks to Increasingly, REITs also will look to leveraging capital by attract interest, and the change in the tax laws takes away some partnering with pension funds in side-by-side investments, of their dividend advantage.” including in operating companies, while retaining property For 2004, expect REITs to deliver their strong suit—6 to 7 management and other associated revenue streams. “REITs’ percent dividends—but not much price growth. If office com- place is to venture with other capital,” says a developer. panies surprise investors with downward earnings revisions, bad “They’re big, stable, nonentrepreneurial owners. They remind press generates property-market jitters, and the overall stock me of insurance companies in the eighties.” market continues to advance, then property stocks could take a What a difference a decade makes. short-term hit as momentum investors split. Only improving earnings will lift REIT prices, and that is a challenging short- Pension Funds term prospect given the space markets. Ongoing Struggle to Boost Allocations More and more, institutional investors will be motivated by a need to produce Consolidation and Slow Growth Belying their roots in greater income in order to meet payout obligations for escalating freewheeling development companies and private family busi- numbers of baby boomer retirees. Pension funds realize that real nesses, REITs increasingly look “more institutional” and “cor- estate yields fit their revised benefits models, and the stage has porate.” During the past ten years, they have introduced the been set for increased investments—both equity and debt. But industry to “cycle-tested management approaches” and “sophis- plan sponsors have been battered by recent stock market losses ticated business practices,” which many private investors have and underfunding predicaments. “Increasing real estate allocations adopted in turn. Inclusion of companies in the S&P 500, Mid won’t solve pension fund problems,” says a pension executive. “Much bigger issues are facing funds in the immediate term.”

24 slack.

so low, it makes sense,” says an interviewee. Where allocation Exhibit 3-6 Pension Fund Assets in Equity Real Estate targets have been reached, “it’s either use leverage or stop investing.” But if rates go up, it will be much harder for boards Total Pension Fund Assets (left scale) to rationalize leverage. “It’s been like giving money away.” $8,000B Percent of Pension Fund 5% Until recently, funds also have sidestepped mortgage and Assets in Equity Real Estate $7,000B (right scale) CMBS investments, but now they increasingly examine debt 4% strategies in their search for yields. “They finally realize that $6,000B mortgage investing can help them manage liabilities and, best $5,000B 3% of all, improve income on a risk-adjusted basis,” says a debt $4,000B manager. “Consultants are starting to get on board.” If syndicator activity decelerates, pension funds are posi- 2% $3,000B tioned to pick up some of the slack. $2,000B 1% $1,000B Exhibit 3-7 Foreign Investment in U.S. Real Estate

$0B 0% ´88 ´89 ´90 ´91 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ´01 ´02 ´03 as of December 31, 2002 Canada 13.5% Sources: Money Market Directory, Rosen Consulting Group. Asia except Japan Germany 7.6% 10.9% Japan Luxembourg Under any circumstances, plan sponsors move with dedicat- 23.6% 0.2% ed inertia. Fund executives are paid to be cautious and even Middle East more cautious. Allocation studies “have been accelerated” and 2.0% Netherlands 10.6% influential consultants who were reluctant to recommend real Africa estate in the past “are now gaining religion.” At board meetings, 0.4% United Kingdom “everyone loves us as long as we continue to provide positive South America 10.7% Other Europe returns,” says a real estate pension adviser. 9.3% Switzerland 1.1% 10.1% “But no CEO will go above 20 percent real estate allocations [of total investment portfolios] and it’s tough enough to Sources: Survey of Current Business, Department of Commerce, Bureau get 10 percent,” says an interviewee. Overall, it’s even a struggle of Economic Analysis, Rosen Consulting Group. to achieve pension allocations above 5 percent. (See Exhibit 3-6.) “Don’t expect a drastic change; increases will inch along.” Adds a major public fund executive: “Everybody says we have bigger Foreign Investors allocations, but I haven’t seen the cash to prove it.” Ultimately, a German syndicators stay active in the 24-hour office markets rising stock market could boost pension flows into real estate as and in southern California—their lower cost of capital and part of a reverse denominator effect. lower yield expectations give them formidable purchasing power. A weaker U.S. dollar combines with relative economic Discipline and Leverage. In fact, most pension funds have stability and market transparency to make investing here partic- been relatively disciplined players in the current property mar- ularly enticing. Middle East and Israeli investors become more kets. “They realize that buying steady income is a risky bet active—they park money in America as heightened conflict right now when other sources of capital are driving higher upends their backyards. Asian investors “are missing in action,” prices and lowering cap rates,” says a leading adviser. “Many preferring to focus on the home front. Japanese banks and funds are standing on the sidelines,” waiting for markets to insurers continue to divest from an ill-timed 1980s buying improve. “They have long institutional memories of grim losses binge and show no inclination to return. in the early-nineties downturn.” Uncharacteristically, funds are now using leverage in their deals in order to elevate returns and stay competitive with aggressive syndicators and offshore bidders. “The cost of debt is 25 “The real estate debt markets will move from substantially overcapitalized to just

Wall Street tainly have captured builders’ attention. “If we were to go for a Investment banks and money management firms expand their spec loan today, we would lose all credibility with the lender,” real estate capabilities to take advantage of the industry’s revived says a developer. “We now know to discipline ourselves in the reputation. Following the money trail like sharks to blood, they borrowing process.” want to appropriate a larger share of syndicator action in the retail markets, tap further into high-net-worth investors, and Exhibit 3-8 Underwriting Standards Forecast

expand relationships with pension funds. Since prospects for Predicted Change in Stringency of Underwriting Standards for their opportunity funds have waned, bankers realize they need Commercial/Multifamily Mortgages in 2004. core products and funds—both public REIT and private real estate accounts—to provide sought-after income-oriented returns. Real estate–related 401K options broaden through mutual fund and defined-contribution offerings. Although banker opportunity funds languish, they have cash to burn if distressed selling ever begins. 12.4% Standards will 50% Standards will 37.6% Standards will become less stay the same become more Life Insurers stringent stringent Same old story—their equity real estate portfolios continue to wind down. Source: Emerging Trends in Real Estate 2004 survey.

Banks register good earnings and show ample reserves— Capital Trends: Debt their first-loan positions seem secure. “Nobody is getting beat Debt should remain plentiful during 2004, but increasing up by real estate this time around.” Life insurer portfolios also defaults and delinquencies will force lenders to become more appear sound. Both banks and insurers are spreading risk by prudent and tighten underwriting, requiring more equity from securitizing portfolios into the CMBS markets, and commercial borrowers. Mortgage rates will stay low but trend upward during construction lenders insulate themselves by routinely syndicat- the year. “Higher delinquencies will mean that loan-to-value ing larger loans. Some regional bankers may have shown a lack ratios head down and debt service coverage goes up.” Increasing of discipline, financing the rash of multifamily development in cost of capital could put modest upward pressure on cap rates. many markets. Fannie Mae and Freddie Mac also raise eye- “The real estate debt markets will move from substantially over- brows in the apartment-lending arena. capitalized to just amply capitalized,” and borrowers’ best opportunities will come earlier in the year. Brimming Watch Lists For all the talk, 2004 should determine just how healthy private-lender portfolios really are. “It will be a critical year.” Delinquency and defaults have edged up, Bankers and Insurers though they still trend near historic lows for the bottom of a real Kudos for Lenders Interviewees lavish praise on bankers estate cycle. “Nobody has even blinked,” says an interviewee. and insurers for providing discipline over the recent investment But watch lists are brimming, and most observers expect cycle. “They’ve done a great job.” Whether praise is deserved problem loans to increase as markets bottom out and struggle or not should play out in any borrower shakeout during 2004 to recover. “It really shouldn’t be this good,” says a lender, con- and 2005. Most lenders—scorched by prior lax practices—did sidering vacancy numbers and rent declines. “Any delinquency/ relatively conservative underwriting in the 1990s. In particular, default increases should be manageable [even if they double to “construction lenders concentrated on preleased, presold, or 3 percent], given the low numbers up until now.” solid asset classes” like multifamily. Stricter loan policies cer- Wizened lenders point out: “There’s a whole generation of investment officers who have never been through a default.” Even more telling, a whole new capital sector has yet to experi-

26 amply capitalized.”

ence the exigencies of an extended market downturn. How CMBS markets handle increasing turbulence will be a clue to the future of the debt markets.

Exhibit 3-9 Life Insurance Company Delinquency and In-Foreclosure Rates

10%

In-Foreclosure Rates 8% Delinquency Rates

0% ´88 ´89 ´90´ ´91 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ‘01 ‘02

Source: American Council of Life Insurers.

Basel II Some bankers red-flag the potential impact of capital regulations proposed under the Basel II Accord. These international regulations would impose higher capital reserve require- Exhibit 3-10 CMBS Market ments for lenders on real estate transactions, based on credit Issuance (left scale) risk. In particular, construction and development financing $100B $350B could become more expensive and restricted, requiring more CMBS Cap (right scale) equity and increasing the need for mezzanine debt. The reserve 300 requirements also would extend to securitized loans. While the $80B 250 regulations would not take effect until 2007, banks will need to $60B start bringing their portfolios into compliance before then. Real 200 estate could look a lot less inviting for banks and their balance 150 sheets. These changes bear careful watching. $40B 100 $20B CMBS 50 Mild Concerns “The stress test is just beginning in the $0B 0 CMBS markets,” says an interviewee. “Performance has ´90 ´91 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ´01 ´02 ´03 nowhere to go but down.” Respondents are generally confident 2Q that most investors in commercial mortgage–backed securities Sources: Federal Reserve, Commercial Mortgage Alert. will weather downdrafts from rising problem-loan rates. “I’m losing a little sleep—not a lot.”

27 Expect bond buyers to “become more wary” as delinquencies and foreclosures

“If the markets pick up, CMBS will be fine. If markets bounce Ignominy in the Spotlight Any CMBS defaults will be along at bottom for a while, they’ll still be OK.” This is especially public events, befitting public securities. “Everyone will know.” true for loan pools concentrating in apartments, where an active Borrowers will be tested on their willingness to put more dol- sales market gives owners exits, and in retail, which has avoided lars into properties or face outing. Private lenders offer more any marked distress. But there is concern about bonds with office cover and greater pliancy. “If you want the cheapest cost of loans. Capital needs—for concessions, tenant improvements, and debt, then you go CMBS, but if you want flexibility when retenanting costs—could create problems for some borrowers. times get tough, it’s not a good choice,” says a developer. Some “Debt guys are understating the potential trouble.” Loan pools borrowers may be in for a lesson or two. heavily weighted in suburban office bear particular scrutiny. “Lots “CMBS foreclosures could be a disaster,” warns an intervie- of leases are rolling over into very soft markets.” wee. Workouts are difficult, and servicers have little flexibility A reasonable uptick in delinquencies and foreclosures to within documents to reduce principal. But owners may try to anticipated 3 percent levels “shouldn’t worry investment-grade stall foreclosures through lawsuits and bankruptcies—a costly or BB bondholders,” says a portfolio manager. “That’s less than and time-consuming process. “If 3 percent of loans are involved, people had calculated in their underwriting.” For unrated bond- that’s a lot of workouts. It could get ugly.” Most interviewees holders, underwriting also “has been holding up.” Some issues expect a latent recovery to puncture such Cassandra prophecies, will experience “de minimis problems”; others “could get but defaulting borrowers will be discomfited and there will be a whacked.” But these investors have earned extremely high cash learning curve for investors and servicers, too. returns to date on their unrated bonds. “In the context of their overall portfolios, they will have earned good returns no matter Returns Slacken Investors’ hunger for CMBS grows, and what happens.” In fact, over the last ten-year cycle, CMBS have Wall Street issuers “keep blowing issues out the door” at a pace “materially” outperformed most alternative fixed-income vehicles. exceeding $1 billion a week. Lending discipline has slipped on some senior debt, fueled by investor appetites and low interest rates. “Investment bankers are acting the part of clearinghouses. For most of 2003, loan-to-values have been going up and debt service coverages have been heading down” in a weakening environment. Most observers stress that B-piece underwriting has held up. “Investors have been savvy enough to force B issuers to have some skin in the game.” Rating agency oversight provides additional discipline. Returns, meanwhile, have been declining, and spreads nar- rowing. “Real estate has been a safe haven, but good credit- quality deals translate into lousy yields. In particular, relative value is gone from investment-grade CMBS, compared to other high-yield bonds.” Expect bond buyers to “become more wary” as delinquencies and foreclosures increase during 2004. Spreads will widen again. But absent unforeseen disaster, the newly earned “mainstream” status that CMBS have achieved in the fixed-income markets should be cemented further. Whole-loan lenders—insurers and commercial banks—will continue to use CMBS markets as an

28 increase during 2004.

outlet to securitize portfolios, manage balance sheet exposure, Return Expectations Down Return expectations have lay off risk, and provide liquidity. Pension funds’ investing been working down from high teens to mid teens, and now low should build—they’re always late to the game anyway. teens, but arguably they are still attractive. “The medium tier in Over the next decade, the CMBS share of the debt markets the capital structure can achieve great yields on a risk-adjusted could increase north of 25 percent, but private lenders will con- basis, almost as good as equity. And you have the equity cush- tinue to dominate mortgage volumes. The less distress and the ion.” But lenders need to focus on stable cash-flowing assets fewer workouts markets endure in coming months, the faster and avoid development risk. With concerns about rising inter- the influence of CMBS will rise. est rates, current borrowers are looking for longer fixed terms— seven instead of five years. Mezzanine Debt “You don’t hear much about mezz workouts—they’re nego- tiated privately.” But interviewees suggest that owners who Tough to Invest Like CMBS in the public markets, mezza- loaded up on mezzanine debt four and five years ago at market nine debt in the private mortgage markets has “tranched out highs could be suffering in the wake of declining operating rev- risk,” protecting senior lenders from first-loss exposure. “It’s enues. These borrowers may have trouble refinancing, if and become an accepted mode of financing.” But like opportunity when mortgage rates increase and mezzanine debt matures. It’s funds in the equity markets, mezzanine investors hunt desper- odds-on that borrower surrenders will increase in 2004. ately for good investments that meet their higher yield requirements. “Deals will be less lucrative than advertised,” admits a portfolio manager. “Liquidity and low rates have limited the opportunities to put money out.” Most interviewees agree: “Too much mezz money has been available.”

29 Markets chapter 4

“Realistically, only Washington, D.C., earns unwavering

endorsement.”

Watchlengthening real estate downturn saps the lineup Other metropolitan areas sink into a gray morass. Normally, of choice real estate markets. Realistically, only interviewees gush with opinions on regional markets—both AWashington, D.C., earns unwavering endorsement. favorites and flops. Not so this year, when interest rates, capital Southern California retains a strong following, though the flows, and financial engineering have distracted them from the state’s fiscal crisis raises some concerns, and New York hangs impact of market vacancy rates and local demand drivers. The tough—it is too big and powerful to be knocked off its feet. fundamentals temporarily—and we stress temporarily—do not After that, “Ugh!” Except for Miami, which continues to seem to matter as much. If the property has the right kind of strengthen modestly, real estate markets from coast to coast tenants, the lease term is long enough, and low leverage can be slide along bottom, and interviewees anticipate little improve- smacked onto the deal, where that sucker happens to be located ment during 2004. is not as important. Or is it that D.C. and New York are the Perennial 24-hour heavyweights—Boston, Chicago, and San only places providing term and credit? Francisco—reel from a lack of tenant demand. But everyone In fact, Washington, New York, and the southern California assumes they will climb back eventually. Not so for the once- duo—Los Angeles and San Diego—are the only markets that hot growth markets—Atlanta and Dallas. Even though these solidify favorable positions in the Emerging Trends risk/return “sprawldoms” might ramp up their expansion engines someday, diagram. (See Exhibit 4-1.) Most other markets slip marginally confidence in their ability to sustain returns has dissipated. deeper into lower-return/higher-risk territory. That is bad news now that real estate investors have been sold “Mainstream” development needs to take a hiatus. For on yields and increasingly gravitate to core properties with pre- 2004, “you have a choice if you’re a developer—head to the dictable cash flows. beach or play some golf.” Only D.C. and southern California rate even mediocre development prospects in our survey.

31 First-tier cities remain vibrant and dynamic, but much of the remainder of urban

Exhibit 4-1 Metro Areas—Return and Risk: 2004

10 Higher Returns Higher Returns Lower Risk Higher Risk 9

7 Washington, D.C. Los Angeles New York San Diego 6 Miami Boston Chicago Return San Francisco 5 Seattle Las Vegas Denver Philadelphia Phoenix Atlanta 4 Minneapolis San Jose Dallas St. Louis Detroit 3

1 Lower Returns Lower Returns Lower Risk Higher Risk

0 1 234 56 78910 Risk

Source for all exhibits in Chapter 4: Emerging Trends in Real Estate 2004 survey.

32 America is ignored.

apartments, turning parking lots into Exhibit 4-2 Markets to Watch Investors parks, and transforming gloomy side streets into neighborhood shopping dis- Investment Development Gravitate to tricts—will become a major driver of development activity in the next decade. 6.7 Washington, D.C. 5.2 the Coasts Dallas and Phoenix will need to follow Los Angeles 6.4 the example. 5.1 Coastal population magnets—the West San Diego 6.3 In Midwest breadbasket markets— 5 Coast from southern California up to New York 6.2 except for Chicago—prospects decline. 4.8 Seattle, the prime Eastern Seaboard cities, Miami 5.7 Their agricultural and manufacturing 4.4 and south Florida—increasingly draw the Chicago 5.6 underpinnings have withered slowly and 4 bulk of investor attention. The Pacific Boston 5.5 Coast faces the growing Asian economies, steadily. Young people see fewer opportu- 3.6 San Francisco 5.1 while the Northeast is the most economi- nities and move away. “The middle of 2.9 Seattle 4.9 cally diverse and stable region, featuring the country seems to be emptying out.” 3.3 Las Vegas 4.9 barriers to entry and extensive mass trans- The number of truly prospering urban 3.9 Tampa 4.6 portation networks. Florida’s attractive centers continues to decline. “For every 3.4 Philadelphia 4.6 climate and Latin America gateway status New York or Chicago, there are ten Tulsas 3.3 or Buffalos.” First-tier cities remain vibrant Baltimore 4.5 grow more enticing. 3.5 and dynamic, but much of the remainder Phoenix 4.5 Some medium-sized southeastern cities 3.2 of urban America—especially the older Houston 4.4 are emerging—Jacksonville, Nashville, 3.1 Rustbelt towns—is ignored. To investors, Portland 4.4 Charlotte, and Raleigh-Durham. “They 3.3 they have become irrelevant. “It’s a hand- San Jose 4.3 have enough critical mass and infrastruc- 2.4 ful of elites and a huge group of dogs.” Minneapolis 4.3 ture, and still project soul and character.” 3.1 But to prosper and “have a chance, they Jacksonville 4.3 3.4 need to take the emphasis off the car” and Denver 4.3 2.5 avoid getting strangled in traffic conges- Hanging On Orlando 4.3 3.3 tion. These places “shouldn’t try to be Austin 4.2 2.4 another Atlanta,” which is “on the cusp Despite Budget Charlotte 4.1 2.9 of being too big to fix.” Atlanta 4.1 In the Mountain West and South- 2.6 Stress Dallas/Fort Worth 4.1 west, open space and sprawl remain the 2.7 Notwithstanding budget shortfalls, revenue Salt Lake City 4.1 obstacles to achieving more reliable and 2.9 declines, service cutbacks, tax hikes, and San Antonio 4 sturdy real estate markets. In the short 2.9 reduced federal aid, the big 24-hour cities Nashville 3.8 term, attractive lifestyles, a favorable cli- 3 have managed to keep up appearances St. Louis 3.7 mate, and a lower cost of living in these 2.9 while waiting out the economic doldrums. Indianapolis 3.7 areas will draw some companies and 2.8 Most important, crime remains tamped Tucson 3.6 workers away from troubled California. 2.8 down. But infrastructure maintenance gets Columbus 3.5 Down the road, legions of aging baby 2.6 back-burnered, and troubled school sys- boomers will resettle in mountain and Milwaukee 3.4 tems fester. “These cities require massive 2.7 desert resort areas. Denver and Houston Memphis 3.4 capital investment” to remain viable. 2.8 take encouraging steps to refashion their Detroit 3.4 Extended belt-tightening could begin 2.6 downtowns into more multifaceted 24- Cleveland 3.4 to undermine quality of life. Potholes, 2.5 hour cores—both featuring growing, New Orleans 2.8 uncollected trash, increased homelessness, 2.1 though small, residential components. Oklahoma City 2.5 and more street crime are possible byprod- 2.1 In fact, efforts to revive once-moribund 0 10 ucts. But interviewees maintain confidence nine-to-five downtowns like these— Poor Excellent redeveloping empty office space into loft 33 Places with reputations for erratic power service could be big losers.

in the staying power of these cities and ruptured, cutting off supplies to many systems that have subsidized horizontal expect them to withstand economic hard- service stations and leaving people with- growth. “The market’s heightened sensitiv- ships. What a difference ten years makes! out transportation in a car-dependent ity to the environment has led to a higher At the depth of the last recession, major expanse. What happens to suburban degree of government regulation and more East and West Coast cities (except for America if an oil crisis strikes, curtailing controls—out of necessity for preserving Washington, D.C.) plunged to the bottom imports and supplies? Since 1979 and quality of life.” Suburbs also get a bad rap of the Emerging Trends rankings. the last Arab oil embargo, U.S. reliance from public health experts. “Drive every- on the car has mushroomed exponential- where” lifestyles encourage weight gain ly—spurred by population shifts out of and related medical problems—suburban urban and rural locations into the auto- dwellers average six pounds heavier than Power, Water, addicted suburbs. It is true that strategic their urban counterparts. and Oil oil reserves and new oil sources from Developers must recognize, if grudg- Russia and other former Soviet republics ingly, the shifts in demand and the 2003 brought us droughts, water short- might help mitigate shortfalls. But given reduced availability of open space. “The ages, a summer blackout, and $2-plus the precarious situation in the Middle gun-toting days of the suburban developer gas prices—all serious concerns for real East, is it farfetched to believe that just throwing up a project are over in most estate investors and developers. Reliable another oil shortage is possible—that places.” Increasingly, greenfield subdivision power is critical for businesses dependent pump prices could rise to the point construction is “heading into the tank.” on telecommunications and computer where the economy and consumers systems. Bang away on a portable type- would take a broadside? The threat is Demographics Push writer and you are liable to be commit- greater now than it has been in a genera- the Move Back in ted. Everything runs off of electricity, tion, and the impact on where people Baby boomers continue to influence mar- including cell phone transmitters and will choose to live could be dramatic. laptop batteries. Places with reputations ket trends as they shy away from subur- for erratic power service could be big los- ban perimeters and look back toward the ers as tenants become ever more motivat- urban cores. In the 1970s and 1980s, ed to disperse operations and reduce the Is Suburban boomers extended the suburban enve- risk of costly shutdowns. lope, raising families en masse in single- Water availability will shape future Expansion family expanses close to good schools and development trends and short-circuit the far from big-city problems. Now, some ability of some states and cities to grow. Approaching “front-end” empty nester boomers (in Not only arid western regions, but also their late 50s) are trading those roomy areas from the Northeast through the Its Limits? split-levels for more manageable urban Carolinas into Florida must face up to Population growth continues to flow into condominiums. Not coincidentally, inconstant or, worse yet, diminishing water densifying suburbs—whether around the urban life has become more attractive— supplies. Can Arizona cities keep on build- built-out 24-hour cities or into the Sunbelt cities are cleaner and safer, and “there’s a ing golf courses? Will southern California suburban agglomerations. “If you’re invest- lot more to do than in your sleepy back- balance agricultural demands with popula- ing in housing or retail, that’s where you yard.” That means more high-rise apart- tion needs? Will looming water shortages want to be.” But less desirable aspects of ments in prime subcities like Atlanta’s in the Apalachicola-Chattahoochee-Flint sprawl—car dependence, congestion, and Buckhead and Midtown or townhouses watershed halt metropolitan Atlanta expan- infrastructure stress—are starting to push in D.C.’s Alexandria, Virginia. Baby sion? The questions multiply. people away from the suburban edge and boomer offspring, the generation X Phoenix was almost brought to its closer to more convenient subcity nodes. crowd, seek jobs and action closer to city knees recently when a gasoline pipeline Increasingly, state and local govern- centers, too, pushing demand for rental ments are enacting growth restrictions to apartments near urban nodes. protect dwindling open space and reduce strains on the costly sewer, water, and road

34 Smart Growth ■ Zoning restrictions: “Old-model” expensive. Many developers will be on Gains Force single-use zoning separations continue to the sidelines until they see what works in be favored by many local governments, the new environment.” Increasingly, buyers are more discrimi- which compete against each other for nating and focus on better-planned sub- projects and tax base generators (office Urban Infill Gears urbs. “Areas that stand the test of time parks, retail strips, and subdivisions). Up Fitfully are generally the older towns with street Developers “flock to the remaining Rehabbing underused nine-to-five down- grids and retail centers.” Convenience growth-friendly places where less regula- towns and other urban infill will also counts: walkable communities near mass- tion usually translates into greater profits.” move to center stage for developers. So transit hubs “have caught on,” and ■ NIMBYism: “Not-in-my-backyard” far, most initial attempts have been “too smart-growth projects—which emulate attitudes and an enduring bias against boutiquey”or “undercapitalized” or have traditional town centers—enjoy increas- density—suburbs are not supposed to suffered from a lack of experience. Risk ing success. “If people like it, the market look like cities. and uncertainty have deterred investors. will push its growth,” says an intervie- ■ An aversion to centralized planning “What you need is a big guy with the wee. “Smart growth is better than dumb and regional control. capital and expertise to join forces with a growth, and it’s about to become more “Intelligent upfront planning is key,” city and make it work.” REITs are not the predominant.” It responds to what peo- says a CEO of a major development firm answer—“analysts would eat them up and ple are most concerned about—“quality that has undertaken smart growth initia- principals have too much stock at stake.” of life and the environment.” tives. “It takes a combination of plan- Institutional investors—focused Meanwhile, suburban degeneration ners, government leaders, developers, and increasingly on surety of income and assaults older, cookie-cutter housing stock, the community. You need wise gover- immediate returns—dodge large-scale especially in first-generation inner-ring sub- nance with a regional, not a parochial, urban revitalization. Mutual insurers that urbs. Some of these areas face deteriorating view—and developers who want to cre- benevolently financed urban renewals in property values, akin to urban declines in ate something that will last.” the 1950s and 1960s are now public the 1960s and 1970s. Over the next The best infill results occur when companies facing quarterly bottom-line decade, more communities will be at risk. large properties—forlorn greyfield malls scrutiny. Banks that were once home- or abandoned industrial sites, for exam- town or regional institutions are now ple—can be developed into pedestrian- Developers Focus more likely parts of national or interna- friendly, mixed-use residential neighbor- on Infill tional financial giants. Their community hoods that include town center retail, The confluence of the “move back in” trend, dedication is not what it used to be. parks, and even schools. These tracts can growth controls that limit new construction, Large public pension funds eagerly give be leveled and builders can start from and suburban degeneration have refocused lip service to supporting local initiatives, scratch without trampling on existing developer and investor attention squarely on but remain exceedingly risk adverse. neighborhoods. “Local government infill opportunities. While Emerging Trends “Risk hasn’t been reduced enough for needs to mitigate the risk for investors interviewees give overall development the big developers and investors to come and developers and provide greater tax prospects an anemic 3.5 on a rating scale in,” says an interviewee. “That’s why you’ll incentives.” The future payback in of 0 (terrible) to 10 (excellent), they award see small to mid-sized projects to begin restored tax base can be immense. “But a healthy 5.9 to infill redevelopment. with. A workable model will be 100 to developers will need to work more coop- Major hurdles need to be overcome in 200 residential units—sales and rentals, eratively with local governments” to take order to fuel the regeneration of infill land: some office, maybe a small boutique hotel, advantage of these opportunities. ■ Profitability requirements: Rehabbing and service retail, near other amenities like “We’re only in the first chapter of the costs more than greenfield construction, parks or an entertainment complex.” changeover from growth and sprawl to and most developers would rather make infill and mixed use,” says an intervie- a buck than go broke building “a subur- wee. “The new model will be more ban Paris.”

35 The diverse southern California basin has been an investor magnet, especially for

Southern California New York The Best and Better than the rest but not vibrant, the diverse The Big Apple’s long-term challenge is stem- southern California basin has been an investor ming job leakage. “Wall Street is no longer the the Rest magnet, especially for apartment and industrial fatted calf.” Events like 9/11 and the 2003 Washington, D.C. buyers. Supply constraints, NIMBY backlash, blackout spur corporations’ job-dispersion and environmental regulations limit multifamily strategies. Backbone financial firms “want less Always the first choice when real estate mar- construction, and enormous renter demand out- dependence on New York.” Despite still-sky- kets hit bottom, the District has not disappoint- strips supply. “Unbelievable” warehouse markets high prices for trophy towers, the city may not ed. It is the only major city to keep office boast miniscule vacancy, and development is rebound quickly or be able to reclaim the heady vacancy comfortably under 10 percent. only starting to ramp up. Asia-facing ports bene- aura of the late 1990s. Yet Manhattan’s unique Although downtown may be “the ultimate yield fit from a shipping influx. Even so, “between us dynamic of money, culture, power, sophistica- buyer’s” market, “pricing above replacement girls, capital needs to slow down. It’s been a tion, and glitz “make it the place to be if you cost has been frightening,” and speculative feeding frenzy.” The real weak spot is the office want to be a global player.” Midtown is solid office projects are underway. “If you overpay markets: “values have been artificially high, for now—“everyone wants to be on Park for something, Washington is the place to ignoring lowered rents.” Optimists again tout Avenue”—but major office construction proj- make a mistake.” While the government cush- downtown L.A.’s future (yawn), but new residen- ects move toward completion. Downtown will ions downside with a prodigious leasing tial “has been a drop in the bucket.” The west stay soft. “Rents won’t come back for several appetite, few tenants show signs of expansion. Los Angeles, Pasadena, and Glendale markets years.” In the long term, a planned mass transit “At least the associations, lobbyists, unions, feature much more attractive executive housing. hub, more residential buildings, and open space and lawyers never got whacked like the corpo- Biotech and defense stabilize San Diego’s for- could rival midtown’s amenities. Condominium/ rates.” A surfeit of East End residential con- tunes—but while climate and lifestyle draw tal- coop prices hold up; apartment rents soften struction gentrifies the area around the new ent, it lacks an airport hub. A higher-tax/more marginally. The worst seems over in the city’s MCI Center sports arena, but leads to a tempo- expensive business environment could slow budget crunch, and with the Republican rary apartment glut. Another concern: crime southern California growth trends, as state and Convention coming to town, all stops will be has been increasing—the District reclaims local governments struggle with massive red ink. pulled out to improve the outlook further. “murder capital” status. Suburbs suffer—no Despite political hot air about “no new taxes,” Worries about crime linger—incidence rates post-9/11 boom occurred in northern Virginia lower-cost Arizona, Nevada, and Colorado beck- meander near record lows, but can that last? as expected. “Any activity is inside the on. Somehow, some way, taxpayers foot the Beltway”—the farther out you go, the weaker bills. “Premium,” built-out coastal areas will markets get. Improvement will be slow, absent 8 weather a downturn better than inland centers major defense department outlays.” around Riverside and San Bernardino, where 7 6.2 growth has accelerated recently. 8 6

7 6.7 5 8 6 4 7 6.4 5 3 6 Washington, D.C. 6.3 New York 4 2 5 3 1 4 2 0 3 ´94 ´96 ´98 ´00 ´02 ´04 1 Los Angeles 2 0 ´94 ´96 ´98 ´00 ´02 ´04 1 San Diego

0 ´94 ´96 ´98 ´00 ´02 ´04

36 apartment and industrial buyers.

Miami rollover risk faces problems. “Vacancy is head- sition target) could be ripe for consolidation. The best in the Southeast, Miami jumps ahead ing back to early-1990s levels, and conces- Any rightsizing could dampen a leasing of other faltering markets. Barriers to entry— sions have returned. Free rent may be next.” rebound. Backbone financial-district money the ocean and Everglades—keep land costs The suburbs “are waiting for pain to hit.” Major management firms need sustained stock mar- high. “There’s not much left to build on, and employers that drove growth in the past ket gains and new investor inflows to justify you don’t see crazy development” as in sprawl- decade—Lucent, Tel Labs, Sears, Motorola, renewed hiring. The suburbs have been ham- ing areas around Tampa and Orlando. Latin SBC Ameritech—continue to falter. Owners mered in the tech burnout. “It’s been ugly.” Americans park dollars in condominiums and have been hanging on, but time is running out Meanwhile, investors circle for deals: “I’d be all infill retail strengthens. Population growth and as leases turn over. Interviewees remain gener- over Boston.” Its 24-hour fundamentals and immigration, plus supply constraints, push up ally positive despite the overbuilding and nega- reservoirs of college and university talent make apartment rents. “South Florida is one of the tive absorption. Diversification, a bevy of it “an excellent long-term bet.” nation’s best multifamily markets.” Industrial Fortune 500 companies, a strong mayor, and fades, tracking South American economies, but excellent mass transit systems provide broad 8 should bounce back in any recovery. Office is underpinnings for sustained growth once the “okay.” Infill redevelopment opportunities overall economy perks up. Industrial remains 7 abound, especially rehabilitating over-the-hill a bright light. 6 5.5 hotels and low-rise apartments along the Intracoastal Waterway and beachfront to create 5 Boston upscale residential space with prized waterfront Chicago 8 4 views. Hotels are overbuilt. 7 3 6 5.6 8 2 5 7 1

4 0 6 5.7 ´94 ´96 ´98 ´00 ´02 ´04 3 5 2 4 San Francisco 1 3 “It’s only a matter of time before distressed trad- 0 ing begins.” Workouts, foreclosures, and sales— 2 ´94 ´96 ´98 ´00 ´02 ´04 they are all coming. But so many vultures are Miami 1 prepared to pounce that pricing could be but-

0 tressed. No question, the Bay Area has been ´94 ´96 ´98 ´00 ´02 ´04 Boston through the ringer—and deterioration may Office market contraction will stabilize in 2004 extend into 2004, thanks to fallout from after a rocky slump—asking-rents have California’s fiscal morass. Can Arnold come to Chicago dropped by more than one-third off 2000 highs the rescue? Expect recovery will take time: three A recent ill-timed splurge of downtown office and vacancies have zoomed. Nobody antici- to five years. “At some point, we’ll be wishing development “looks like a train wreck coming pates an immediate recovery: “Tough it out for we’d bought everything we could have when it down the track.” “Simply, Dallas on a lake.” As a couple of years; it will come back.” Yield was available.” Some estimates suggest 175,000 companies downsize or hold the line on space hunters will help prop up prices for leased, or more new jobs must be created before rents needs, new prime space lures tenants out of Class A properties, but lesser-quality buildings increase. The ultimate landlord’s market in 2000 older buildings, “creating holes.” Anything with face a challenging environment. The future of (who were the guys who signed $100-per- two significant employers raises concern— both John Hancock (to be acquired by Canada’s Manulife) and Fleet Bank (another prime acqui- 37 Unremitting growth has caught up with Atlanta.

square-foot rents?) has turned into a tenant’s ingly, apartments struggle, too. A tech revival Phoenix paradise (rents are back to pre-spike 1997 lev- cannot happen soon enough. Without it, you’re One of the Sunbelt’s high-growth, high-risk els). Hotels struggle in the impaired business “looking at a three- to five-year turnaround.” suburban markets, this desert metropolis climate. The only good news: office and hotel improves slightly, if only because capital has development has shut down. Conversion of shied away. A shallow, “out of whack” office 8 office into residential makes sense, though. market suffers and apartments are overbuilt. The housing market remains tight. 7 Construction has been “amazing” except in downtown, which “desperately” needs a resi- 6 8 dential core. Retail does well and the stellar 5 golf resorts draw snowbirds, but most institu- 7 Seattle 4.9 tional investors just steer clear. “You can’t stay 4 6 ahead of the development curve and make 3 money—they build too quickly.” The city could 5 5.1 benefit from California’s problems. An excellent San Francisco 2 4 labor force and affordability “have practically 1 turned it into an L.A. submarket.” 3 0 ´94 ´96 ´98 ´00 ´02 ´04 2 8 1 7 0 Philadelphia ´94 ´96 ´98 ´00 ´02 ´04 Philly muddles along at cyclical bottom, 6 starved for action and lost in the shadows 5 between formidable neighbors, D.C. and New 4 4.5 Seattle York. It is off most interviewees’ radar screens. “Well, it’s not looking good.” Boeing keeps the Office leasing goes sideways, investor interest 3 pink slips coming and Microsoft outsources is limited, and construction has halted, thank- 2 Phoenix jobs overseas, taking advantage of its very own fully. Prime suburban markets—King of technology products and innovations to help Prussia and Conshohocken—may offer some 1 manage local space costs. Job growth has good buying opportunities if office owners 0 dried up (Washington boasts one of the start to capitulate. Suburban vacancy outpaces ´94 ´96 ´98 ´00 ´02 ´04 nation’s highest unemployment rates), vacan- downtown’s. Retail and apartments hold their cies should top off in the high teens, and rents own. Lethargy will persist through 2004. have more room to fall. Most development Houston activity has stalled, offering a faint note of 8 A reviving central business district—with hope. Some skeletal projects have even been upscale residential development, restaurants, a 7 mothballed. No one can figure out the next sports arena, a convention center, a stadium, employment generator. Expect a quicker recov- 6 and light rail—burnishes Houston’s longer-term ery for industrial, which has been hurt by prospects. But the city’s “anything goes” zon- 5 Boeing contractions. “When Asia comes back, ing, lack of barriers to entry, and inherent Seattle’s port will again be a great alternative to 4 4.6 volatility continue to ward off investors. Woeful Los Angeles and San Francisco.” Not surpris- office markets still depend on lurching energy 3 Philadelphia companies to drive demand, while apartment 2 construction spirals out of control. “Texas real

1 estate people seem only to know how to build.”

0 ´94 ´96 ´98 ´00 ´02 ´04 38 and local government initiatives with private devel- 8 Atlanta Unremitting growth has caught up with Atlanta. opers to bring more residential into the lifeless 7 “The infrastructure is a mess and it will be like downtown. A nascent light-rail system helps. 6 turning around a supertanker.” Congestion effectively nullifies chamber of commerce babble 8 5 about desirable lifestyle and reasonable cost of 7 4 4.4 living. The market bottomed in 2003—construction is now curtailed and a once-formidable job- 6 3 growth machine is showing signs of life. Office Houston 5 2 vacancies may descend from 25 percent peaks. But apartment construction chugs along despite 4 1 Dallas 4.1 “negative absorption,” and industrial markets 3 0 suffer record vacancy—they “won’t be healthy ´94 ´96 ´98 ´00 ´02 ´04 for the foreseeable future.” Real estate pros are 2 pondering when to use the old, reliable buy-and- 1 flip play. “It’s a timing market—you buy low, wait Denver 0 for the growth to kick in, and sell quickly.” But ´94 ´96 ´98 ´00 ´02 ´04 A mile-high disaster in the wake of the telecom how much growth will there be in this cycle? Live implosion, Denver bottoms out. Some suburban by the sprawl, die by the sprawl? office market vacancies reach 40 percent and apartment values sink 15 percent below replace- Second Tier Cities ment cost or lower. “When there are sellers, it 8 Some interviewees warm to “overlooked” second- may become a vulture’s paradise.” Like Houston, and third-tier cities, hoping to avoid the investor 7 downtown Denver takes on 24-hour trappings, crowds who bid up prices to uncomfortable levels spurred by new residential projects and the artsy 6 in top markets. “You can get better deals when you LoDo district. Near-term hopes rest on a tide of get away from the herd, but you need to under- 5 stand the risk.” In fact, the downside can be sub- California businesses seeking out the lower-cost Atlanta 4 Rocky Mountain alternative, which features 4.1 stantial. With thin tenant bases and little diversifica- affordable housing, comparable recreation, less 3 tion of local industry, the loss of a large tenant or a smog, and less traffic. cyclical business downturn can be devastating. 2 Limited investor interest restricts exit strategies. 8 1 “Shocks run deeper and you have less liquidity.” “Focus on cities with little new construction, 7 0 ´94 ´96 ´98 ´00 ´02 ´04 and buy the best assets—the newest, well leased,” 6 says an interviewee. State capitals and places with 5 universities draw notice—Birmingham, Tallahassee, Dallas/Fort Worth Columbia, and Greenville (South Carolina), as well 4 4.3 Denver The industry whipping boy takes more lumps: as Boise. “But you’ve got to be the first one there.” 3 “The market is just awful.” Metroplex saddle Most larger second-tier Sunbelt markets— sores include: “phenomenal” overbuilding, Orlando, Nashville, Austin, Charlotte—get 2 employer woes (American Airlines, JCPenney, lumped together in negative sentiment about 1 telecoms), no barriers to entry, and ebbing Atlanta and Dallas. Las Vegas improves—all the glossy hotel/resort development sparks new 0 investor interest. “I just don’t know how to ´94 ´96 ´98 ´00 ´02 ´04 underwrite an office building there.” “You can’t jobs and attention. Midwest industrial cities are time the boom/bust anymore—it’s mostly off the radar screens. bust.” “Properties are just commodities.” Local boosters point to subdued construction levels 39 Propert Types chapter 5

“For the first time in this survey’s history, grocery-anchored retail y gains the top spot.” in Perspective

ost property sectors will bounce along market bottom Exhibit 5-1 Property Markets: 2004 Prospects in 2004, improving by year-end. Only office appears significantly challenged. Investment prospects are Investment Potential M Development Potential muted, but risk assumptions level off among Emerging Trends survey participants. Development activity—already slowed— Neighborhood/Community 5.6 promises to diminish further, especially in the office and apart- 5.2 ment markets where a space overhang limits opportunities. Industrial–Warehouse 5.5 5.0

Apartments 5.2 Favored Sectors 4.6 Regional Malls 4.6 Interviewees continue to favor investments with less volatile, 2.9 more predictable income streams—the “dull” but cash-generat- Power Centers 4.4 ing community shopping center, warehouse, and apartment 3.7 categories. (See Exhibit 5-1.) In fact, for the first time in survey Downtown Office 4.4 history, grocery-anchored retail (at a mediocre 5.6) gains the 2.7 top spot among property types, edging out warehouses’ Hotels–Full Service 4.4 unchanged 5.5 rating. Last year’s leader, apartments, suffers the 2.5 biggest decline in survey sentiment, dropping from 5.7 to 5.2 Industrial–R&D 4.4 as interviewees reflect moderate concern about overbuilding 3.5 and unrealistic cap-rate compression. Suburban Office 3.9 2.4

Hotels–Limited Service 3.5 2.4 0 10 Poor Excellent

Source: Emerging Trends in Real Estate 2004 survey.

41 Office and hotel prices are expected to slip, as some owners in compromised markets

Exhibit 5-2 Property Type—Return and Risk: 2004

10 Higher Returns Higher Returns 9 Lower Risk Higher Risk

6 Community Shopping Centers Warehouses Apartments Return 5 Regional Malls Full-Service Hotels Downtown Office Power Centers 4 Suburban Office R&D Limited-Service 3 Hotels

1 Lower Returns Lower Returns Lower Risk Higher Risk

0 1 234 56 78910 Risk

Source: Emerging Trends in Real Estate 2004 survey.

Overall, the retail sectors achieve their strongest survey posi- prisingly, office appears considerably more risky as its return tion since the early 1990s—the heyday of regional malls. Hopes outlook deteriorates. for continued consumer spending elevate both malls and power In general, prices and yields will stagnate. Office and hotel centers to less tepid rankings than they have earned in recent prices are expected to slip, as some owners in compromised years. Hotels elicit flickers of interest from investors, advancing markets finally begin to sell. According to the interviewees, cap slightly, while office outlooks decline sharply, especially for the rates will stay down, improving the outlook for sellers, despite suburban sector. weak fundamentals. (See Exhibit 5-3.) On the risk/return spectrum, only community centers, Prospects for value growth sag over one-, five-, and ten-year warehouses, and apartments cling to familiar positions in the time horizons in line with expectations that future real estate higher-return/lower-risk quadrant. (See Exhibit 5-2.) Not sur- returns will comprise strong income and modest appreciation. (See Exhibit 5-4.) Only malls and power centers show slight

42 finally begin to sell.

Exhibit 5-3 Capitalization Rate Bid/Ask Characteristics Thin Development SPREAD Prospects Narrow BID ASK (basis points) DEAL Apartments 8.0% 7.3% 70 7.6% Regional Malls 8.2 7.4 80 7.8 Opportunities Downtown Office 8.7 8.1 60 8.4 Developers will need to hunker down in 2004. “Why bother Neighborhood/Community 8.8 8.1 70 8.4 Industrial–Warehouse 8.9 8.2 70 8.5 about development? We’re back in the early 1990s.” Multifamily Power Centers 9.5 8.7 80 9.1 construction has been well ahead of demand. Retail needs are Suburban Office 9.8 9.0 80 9.4 spotty—developers keep building new formats despite an abun- Industrial–R&D 9.9 9.1 80 9.5 Hotels–Full Service 11.0 9.9 110 10.4 dance of empty storefronts and dead malls. And “the need for Hotels–Limited Service 11.9 10.7 120 11.3 new office is four to five years off in most markets.” Only indus- Land 16.3 12.5 380 14.4 trial may see near-term activity, although vacancy rates need to Source: Emerging Trends in Real Estate 2004 survey. come down first. “Speculative building is nowhere in sight— demand has just disappeared.” Generally, development has been kept in check. “The slam-dunk Exhibit 5-4 Expected Value Changes good news is that banks have been disciplined,” says an investor. Risk money becomes increasingly expensive for developers—they Property Type 2004 5-Year 10-Year must bring more equity into projects before they can attract either Neighborhood/Community 2.6% 11.0% 20.8% partners or lenders. Many look to alternative businesses, including Industrial–Warehouse 2.1 10.4 20.8 property management, investment advisory, and deal brokering. Hotels–Full Service 2.0 12.6 23.3 Power Centers 1.5 8.6 16.8 Listed below are the best of a thin selection of development Regional Malls 1.5 9.7 19.8 opportunities mentioned by interviewees: Land 1.0 13.1 25.9 ■ Apartments 0.7 12.7 26.1 For-sale housing in downtown and infill locations, including Industrial–R&D 0.7 8.0 17.6 condominium conversions, loft rehabs, townhouses, and adap- Hotels–Limited Service 0.6 9.8 20.1 tive use projects. Downtown Office -0.6 9.7 19.9 ■ Suburban Office -1.7 8.5 17.0 Low- and moderate-income apartments as well as tax credit housing in urban areas and inner-ring suburbs. Demand builds Source: Emerging Trends in Real Estate 2004 survey. as housing shortages persist for low-wage service workers and immigrant families. ■ Brownfield restoration: “Litigation issues have been identi- improvement over 2003 surveys. In the long term, apartments fied, and brownfields can be underwritten with greater confi- are forecast to appreciate more than any other property type, dence. Risk has been reduced and is more quantifiable.” Old followed by the more volatile full-service hotel category. infill industrial sites make excellent candidates for town center Respondents retain healthy appetites for warehouses and housing. anticipate some bottom-fishing opportunities for full-service ■ Master-planned community development with town center hotels—the two leading acquisition targets, according to the features and design based on new urbanism and smart-growth survey. Retail’s improved status makes for disposition opportu- principles—pedestrian-friendly neighborhoods, open space, and nities—grocery-anchored centers and Class B malls are “too main street retail. pricey,” but buyers have not figured that out yet. The intervie- ■ Student housing in university areas. wees recommend selling apartments into the anything-goes acquisition wave for as long as possible.

43 Hold onto fortress malls, prime neighborhood centers, and the best-located power c

Department stores, in particular, are struggling. Their total mar- Retail ket share (percentage of sales) has declined from over 60 percent Strengths to 40 percent in less than ten years. Some of these mall anchors stand in the crosshairs—they have lost their merchandizing edge “Popular by default,” retail is the only property sector where to the superstore discounters and are surviving on low occupan- rents and occupancies have held up. “Retail never had a reces- cy costs at malls where they pay cents on the square foot. sion. People just kept on spending.” Survivors will gravitate to the fortress malls, accelerating the Grocery-anchored retail is the shining light: “It’s last on the demise of some B and C regional centers. Retail space per capita retail chain to suffer because everyone needs to eat.” But bond- continues to climb to uncomfortable levels. Empty (“we’re not like returns need to be goosed with leverage. Flight to yield has pushed cap rates down to uncomfortable levels. “You’re not buying any appreciation. What you see is what you’ll get.” Exhibit 5-6 Power Center Summary 2004

RATING RANKING Buy 10% Exhibit 5-5 Community Shopping Center Summary 2004 Investment Potential 4.4 5th Development Potential 3.7 4th RATING RANKING Overbuilding Risk 5.6 7th Sell 66% Investment Potential 5.6 1st Buy 27% Development Potential 5.2 1st PREDICTED VALUE GAIN/LOSS Overbuilding Risk 5.1 9th 1 Year 5 Years 10 Years

Sell 50% PREDICTED VALUE GAIN/LOSS 1.5% 8.6% 16.8% Hold 23% 1 Year 5 Years 10 Years

2.6% 11.0% 20.8% Hold 22% overbuilt, we’re underdemolished”) space in abandoned strip centers and dead malls inflates the numbers, but what does that say about tenant staying power and investment risk? Shoppers fall in love with the drive-up convenience, pricing, Anybody who buys retail today “better look over their shoul- and merchandise selection at big-box power centers—now the der at Wal-Mart,” which, with its mostly freestanding stores, nation’s most successful retailers. The format is pushing aside cannibalizes everyone. Unless you have the very best location, weaker regional malls. Investors need to focus on the best cen- you’d better be fast on your feet. This is one property sector ters at the better infill locations. “where you can’t just buy and hold.” The best locations today The top 300 regional malls “can’t be touched—they’re great “can quickly morph into weak ones,” particularly in suburban investments.” These income-powerhouse fortress centers rarely areas without barriers to entry. Community centers need to pro- change hands. Most are controlled by mall REITs, which can vide flexibility for grocery chains to expand into superstore for- leverage their market power to cut lease deals with national mats, “or they could be gone.” Further discounter contraction chain stores. would not be surprising either—Kmart isn’t out of the woods. In case you haven’t noticed, Internet sales nibble into the Weaknesses market shares of bricks-and-mortar retailers. These Web inroads Expect major consolidation among retailers over the next five will continue and become a force—early failures were inevitable years. “Retail has no staying power—it’s only as good as tenant and “e-tailers” (including established chain stores) are figuring credit. Some former major-brand stores have no reason to exist.” out how to build sales and profits. “Younger generations have been programmed to buy off the Web. Now my wife is getting the hang of it!”

44 centers.

Exhibit 5-7 Regional Mall Summary 2004 Development Few regional malls will be built in the future. Demand is limited, and the “interminable” entitlement process becomes more RATING RANKING Buy 9% daunting as environmental and open-space issues grow more Investment Potential 4.6 4th contentious. Recycling potential for failed formats captures Development Potential 2.9 6th Sell 46% more attention. “Main Street” rehabbing of strip centers “trans- Overbuilding Risk 3.8 10th plants urban imagery to safer suburban locations.” Malls were the 1960s and 1970s; Main Street is back-to-the-future in the PREDICTED VALUE GAIN/LOSS new century. Lifestyle centers supplant obsolescent space in 1 Year 5 Years 10 Years more affluent infill locations. Ghost malls make prime targets Hold 45% for mixed-use redevelopment—mostly apartment, townhouse, 1.5% 9.7% 19.8% and single-family, with neighborhood retail to serve residents.

Outlook Best Bets Will shoppers keep spending “like drunken sailors?” It is hard to believe the consumer has strong legs unless substantial per- Hold onto fortress malls, prime neighborhood centers, and the sonal income growth occurs. Home equity refinancing and tax best-located power centers. Sell everything else before investors cuts are running their course. Credit card debt is off the charts. start distinguishing the wheat from the chaff. Neighborhood The economy needs to pick up steam fast. “Chickens may be centers have been overpriced, given the risk of supermarket coming home to roost.” For 2004, look for heady returns to chain failures and the threat of Wal-Mart incursions. Consumer head back down. Retail will deliver solid income, but the loyalty is “extremely suspect—they go after the best pricing.” prodigious run-up in values is over, as capital turns more cau- Only the top one or two grocery chains in each market will sur- tious. Performance will be good, but risk increases. vive, “versus five or more grocers ten years ago.” Weaker centers are extremely risky holds. Sector rotation is likely to strike retail REITs as investors Exhibit 5-8 NCREIF Retail Returns look for more upcycle growth from hotels and apartments. Expect major mall owners to step up their courting of 20% discounters and big boxes. They need fallbacks if anchors go under. That could set off a turbulent round of retailer musical 15% chairs with power and community centers. 10% Avoid B and C malls are the most vulnerable to retailer consolidation. 5% Repeat after me: “Where’s the exit?” Recent purchasers have bought income streams and leveraged them up on cheap debt, 0% figuring they will cash out a return before the center goes dark and then be able to convert the use. Meanwhile, fashion malls -5% ´83 ´85 ´87 ´89 ´91 ´93 ´95 ´97 ´99 ´01 ´03* and lifestyle centers steal shoppers at the high end and discoun- 2Q ters rob sales from the bottom. Constant mall repositioning to ward off competition requires substantial capital infusions. Source: National Council of Real Estate Investment Fiduciaries (NCREIF). “You end up buying malls twice—when you purchase and *2003 returns are four-quarter trailing figures as of second-quarter 2003. when you need to reposition.” They are risky bets.

45 Warehouse vacancy should fall back to under 10 percent, but until it hits 8 percent

Distributors continue to find ways to control inventories, Industrial reduce storage requirements, and cut shipping costs. Radio fre- Strengths quency (RFID) chips attached to shipment pallets help to direct deliveries more efficiently. More tenants are using their “Industrial is always okay.” Unlike office, the warehouse sector own truck containers for storage, taking advantage of ware- typically recovers early in the economic cycle. This time, mar- house site parking. Wal-Mart does this as well, rather than bulk kets already show signs of stabilizing and improving after up on warehouse space. “The bigger your parking yard, the weathering vacancy rates exceeding 10 percent nationally—the more competitive you are.” (But unless parking is figured into highest on record. “Rents haven’t eroded much.” Recent leasing rents, tenants get something for nothing.) Strategies like these tends to be for shorter terms—tenants are hedging their bets on continue to eat into demand growth for industrials, and focus expansion needs until the economic outlook is more certain. owners’ attention on providing short-term distribution space Liquidity is never an issue for this sector. Capital won’t let up— rather than storage facilities. Increasingly, industrial parks with- institutions can’t buy enough. Despite weakened fundamentals out adequate parking, turning radii, cross-docking, and access and stressed income flows, cap rates for warehouse properties for large trucks are at a disadvantage. decline into record territory. “We can’t even compete on acquisitions,” complains a major REIT executive. “The deals have been too aggressive.” Owners turn over portfolios reluctantly— Best Bets it is not easy to redeploy assets. “Everyone is underallocated in Top markets continue to be the larger regional distribution cen- warehouse. They always want more.” ters, near airports, rail lines, and ports—Seattle (“Pacific gateway”), San Francisco (ditto), Los Angeles (“on fire—trade with Asia”), Chicago (“rock solid”), Miami (“Latin America will Exhibit 5-9 Warehouse Summary 2004 rebound”), northern New Jersey (“the Northeast hub”), Atlanta (“national tenants need to be there”), and Dallas (ditto). In RATING RANKING these hubs, focus on the higher-ceiling space that caters to Investment Potential 5.5 2nd national distributors. Although few tenants stack five pallets Buy 44% Development Potential 5.0 2nd high, “you need 24-foot clear at least, and 30-foot is even bet- Overbuilding Risk 5.2 8th ter.” In more local markets, 24-foot is a safe bet. “You don’t have to be a big box—that’s an institutional myth.” Sell 22% PREDICTED VALUE GAIN/LOSS 1 Year 5 Years 10 Years Avoid Hold 33% Don’t even look at older, low-ceiling, obsolescent space that 2.1% 10.4% 20.8% lacks sufficient parking and distribution features.

Development New-construction pipelines are drained, which will expedite over- Weaknesses all sector recovery. Expect development to resume by year-end, but Enthusiastic buyers in recent deals may eventually end up los- record-high vacancies in most markets will curtail the need for ers—or at least disappointed. They have no upside, especially if new space, so activity will be modest. Short construction lead rents temporarily decline further or go sideways in higher- times keep most markets from getting ahead of themselves. vacancy markets. “Prices upwards of 20 percent above replace- Airport tarmac distribution offers a new—but admittedly ment cost for older buildings present a problem when some- small—development niche. Cargo jets pull up and off-load one can develop space next door with bells and whistles.” directly into distribution facilities without intermediary steps. Sunbelt hubs—Dallas and Atlanta—suffer from significant Owners/operators need to negotiate ground leases with the air- vacancies. “Recovery could take a while, but people are paying ports. Given RFID technologies and other just-in-time strata- amazing prices and nobody seems worried.” gems, direct airport distribution could eventually limit warehouse demand around key air-transport hubs.

46 territory rents will not start increasing.

Exhibit 5-10 Warehouse Construction Put in Place Research and Development Outlook Real estate’s most volatile sector, R&D, labors to emerge from tech-wreck rubble. Interviewees have written off the category, 15,000 expecting a delayed recovery. But opportunists hover. “The tech-savaged areas are where money can be made.” In 2004, all high-profile tech markets will languish. San 12,000 Jose, Austin, suburban Boston, and Bellevue (Seattle) remain “knocked out cold.” Some formerly high-flying corporations plan to disgorge owner-occupied space to help their balance 9,000 sheets, which could deflate property outlooks even further.

Millions of Dollars The overseas outsourcing issue also clouds prospects. For owners who can hold on, history suggests that values 6,000 could spike quickly. Undoubtedly, technology-related industries will drive future economic growth, and R&D facilities will benefit. In 2004, R&D markets could serve as a litmus test for vul- 3,000 ´93 ´95 ´97 ´99 ´01 Jul 03 ture appetites and determine whether a rush of capital cushions Source: U.S. Census Bureau. pricing levels. Owners have been able to avoid capitulation, but cash-flow shortfalls may finally force sales.

Warehouse Outlook Warehouse vacancy should fall back to under 10 percent, but Exhibit 5-12 R&D Summary 2004 until it hits 8 percent territory rents will not start increasing. Anticipate income-only returns in 2004. “Don’t expect much RATING RANKING growth in the next few years.” Inventories are tapped out. As Buy 20% Investment Potential 4.4 5th (tie) the economy improves, manufacturers will need to step up pro- Development Potential 3.5 5th duction and distribution to catch up with growing demand. Sell 28% Overbuilding Risk 5.8 5th Warehouses can only benefit.

PREDICTED VALUE GAIN/LOSS

Exhibit 5-11 NCREIF Warehouse Returns 1 Year 5 Years 10 Years Hold 51%

15% 0.7% 8.0% 17.6%

12%

-3% ´83 ´85 ´87 ´89 ´91 ´93 ´95 ´97 ´99 ´01 ´03* 2Q Source: National Council of Real Estate Investment Fiduciaries (NCREIF). *2003 returns are four-quarter trailing figures as of second-quarter 2003.

47 Expect apartment cap rates to increase modestly and operating incomes to stabilize.

Apartments Exhibit 5-13 Apartments Summary 2004

Strengths RATING RANKING Buy 27% “Everyone over two feet tall wants apartments.” Steady income Investment Potential 5.2 3rd and future space demand motivate acquisitions. The echo-boom Development Potential 4.6 3rd surge of young adults (a prime renter cohort) promises to swell Overbuilding Risk 6.2 3rd occupancies through the next decade. “Demographics will be Sell 46% extremely favorable. We just need to get through this low- PREDICTED VALUE GAIN/LOSS interest-rate period and stop building so much.” 1 Year 5 Years 10 Years “Future scarcity affects the pricing model.” Many markets— Hold 28% around 24-hour cities and in southern California and south 0.7% 12.7% 26.1% Florida—are maturing or are built out. An exit strategy exists for almost any stable property in these areas.” Rising interest rates (“they won’t go any lower!”) will slow down homebuying and increase renter numbers. However, current apartment buying is “almost a reverse arbitrage—pur- attractive mortgage rates have not mattered much in southern chasing at such premium cap rates when properties normally California, where homes remain unaffordable for most renters. decline in quality and their cap rates usually increase over time.” As long as vacancies stay high and rents are challenged, owners Weaknesses of B and C product need to make improvements or lose their bet- In most markets, low mortgage rates turn tenants into homebuy- ter tenants to higher-quality buildings. When financially secure ers, restraining apartment demand and pushing vacancies to renters leave, credit problems and attendant rent-collection issues uncomfortable levels. “Luxury rentals are hit hard.” The propor- are exacerbated. tion of rental households has declined steadily since the early Questions arise about the impact of post-9/11 policies on 1990s. “People who struggled to pass our minimum income crite- immigrants. Tougher entry standards may stanch flows of these ria for rentals are now buying homes.” Renter numbers are cut significant renter groups and hurt future demand in immigration further by a jobless recovery that increases “roommating” and the gateways—typically the 24-hour cities. It is still too early to tell. incidence of young adults moving back in with parents to cut costs. Construction, meanwhile, has not stopped. Developers and Best Bets local banks have bought into the demographics story, and investors Take advantage of the buying frenzy and prune weaker proper- keep buying. “It’s been a perfect storm.” Markets with low barriers ties in need of capex. “It’s a great time to be a multifamily to entry are seeing sharp rent declines. seller.” Hold core investments in supply-constrained markets: Some of the activity has been “irrational” buying (low cap southern California, south Florida, and within the halos of rates and cheap debt), dominated by private syndicators and 24-hour metropolitan areas—Washington, D.C.; New York; high-net-worth investors. “Capital risks have not been factored Boston; Chicago; and San Francisco. “The best markets are into pricing.” Recent leveraged acquisitions represent the gamble those with the highest barriers to entry and least-affordable that an economic recovery will overcome a dangerous brew of single-family homes.” falling rents and occupancies coupled with rising concessions Buy into long-term rental markets that are currently over- and tenant improvement costs. If interest rates rise too quickly, supplied, like Seattle, Portland, and Philadelphia—their prices “it’s a bloodbath.” In high-growth suburban agglomerations, offer bondlike returns and you can “ride them out for eventual upside.” These markets will come back.

48 Avoid Exhibit 5-14 Multifamily Residential Construction Bypass overbuilt suburban agglomerations—until the single- Put in Place family housing boom fades. Then move quickly to buy, lease up, and flip. 35,000

Development 30,000

Developers need to back off new construction, especially in 25,000 easy-to-build markets, until rents stop deteriorating and the economic recovery creates jobs. “Apartment construction has 20,000 been in the range of what will be needed annually in anticipation of a demographic burst,” but the spurt is premature. 15,000 “Developers don’t try to time. If they like a market, they just Millions of Dollars 10,000 keep on building.” Blind capital flows fund the boom. As long as interest rates stay low, and where strong buyer 5,000 demand exists, convert rentals into coops and condominiums, 0 tapping into the homebuying crowd. “It’s more profitable.” In ´93 ´95 ´97 ´99 ´01 Jul 03 high-growth markets like Dallas and Phoenix, condominium conversions may ease some developers through the low-interest- Source: U.S. Census Bureau. Data include for-sale condominiums. rate period—but buyers beware: “It’s like purchasing a burial plot. You’ll never be able to get rid of it.” Renovate B and C apartments in anticipation of an economic rebound; you can capture upside when rents advance— Exhibit 5-15 NCREIF Apartment Returns and then sell. 20% New projects increasingly face NIMBY hurdles and zoning restrictions. But infill and urban adaptive uses offer promise, 15% especially near transit nodes. And don’t forget affordable housing. Renter demand will build and build. 10%

Outlook 5% “The bloom is off the rose.” Expect cap rates to increase modestly and operating incomes to stabilize. Rents will be rolling 0% over to lower rates, at least until midyear. “Real rent growth -5% may not happen until 2005.” Any rebound could be sudden— ´83 ´85 ´87 ´89 ´91 ´93 ´95 ´97 ´99 ´01 ´03* “concessions should burn off quickly.” Demographics will even- 2Q tually help demand, “but these impacts are typically slower to Source: National Council of Real Estate Investment Fiduciaries (NCREIF). materialize than we expect, so temper enthusiasm.” Overpricing *2003 returns are four-quarter trailing figures as of second-quarter 2003. means that “no one will make a lot of money for a while,” but over the long haul apartments will deliver.

49 Don’t buy anything with near-term leasing exposure unless you underwrite deteriorating

Office Exhibit 5-17 Suburban Office Summary 2004

Strengths RATING RANKING Prime, well-leased buildings in the 24-hour cities (primarily Investment Potential 3.9 6th Buy 33% New York and Washington, D.C.) attract zealous buyers the Development Potential 2.4 9th way American Idol draws caterwauling contestants. These safe Overbuilding Risk 6.4 2nd harbors—flush with credit tenants and leases signed at late- Sell 26% 1990s market highs—have regained ultimate trophy status. PREDICTED VALUE GAIN/LOSS “You can’t get into too much trouble in stabilized assets.” With 1 Year 5 Years 10 Years inexpensive financing, prices bid up well above replacement Hold 40% cost are more palatable. Owners are advised to hold—these -1.7% 8.5% 17.0% buildings have become rare commodities. “Where will they get better risk-adjusted return with the proceeds?” The last time crème de la crème office towers fetched such sky-high pricing was during the late 1980s, and you know what Office investments feed off white-collar employment happened next. growth, but so far “we’ve had a job-loss recovery.” Any corporate earnings improvements have resulted from efficiencies, lay- Weaknesses offs, and outsourcings—all demand deflators. “You can’t create After the trophies, forget office. Supply/demand fundamentals a magic tenant base.” Much of the 1990s job boom turned out are “as bad or worse” than they were during the early-1990s to be artificial—“false demand.” Once office tenants decide to depression. “It’s ten years ago revisited.” Tenants jump on the hire again, a lot of phantom (empty occupied) space will have lease-renewal bandwagon, hoping to secure low rents and longer to be filled before any expansions occur. “There is no quick terms. “A lot of renewals will be at rates lower than owners want fix.” Recent new leasing activity has been “musical chairs— to anticipate.” The crunch will shock some recent investors who moving tenants around with lower rents and tenant improve- thought they were buying more stable income. Sublease space ments, not expansions.” continues to burn off, leaving owners more exposed. Concession Suburban office—especially commodity buildings—should packages, work letters, and free rent chomp at net operating prepare for a free fall. “Rents are going down big time.” Tenants incomes. “We haven’t seen the bottom yet.” will be able to move around and bargain for lower rates in

Exhibit 5-18 Office Construction Put in Place Exhibit 5-16 Downtown Office Summary 2004 60,000

RATING RANKING Buy 27% 50,000 Investment Potential 4.4 5th Development Potential 2.7 7th 40,000 Overbuilding Risk 5.9 4th Sell 27%

30,000 PREDICTED VALUE GAIN/LOSS 1 Year 5 Years 10 Years Hold 46% 20,000 Millions of Dollars

-0.6% 9.7% 19.9% 10,000

0 ´93 ´95 ´97 ´99 ´01 Jul 03

Source: U.S. Census Bureau.

50 fundamentals into your pricing.

higher-quality space. Premium buildings, located in 24-hour Exhibit 5-19 NCREIF Downtown Office Returns subcity markets, will attract the foraging tenants and withstand the downturn better. 20%

15% Best Bets Hold or buy top-tier, 24-hour (“term and credit”) office—that 10% means lease rosters with minimal rollover risk in the next five 5% to seven years. Add 60 to 75 percent fixed-income leverage at current low rates. “You achieve low-teens returns at low risk.” 0% Good luck finding a deal—and get ready to swallow hard. -5% Exploit potential arbitrage. Patient dollars should find distressed owners eventually, although a ton of money has the -10% same idea. If markets really sink, some capital will get skittish, -15% opening the field. Tech-wrecked markets—the Bay Area, ´83 ´85 ´87 ´89 ´91 ´93 ´95 ´97 ´99 ´01 ´03* Boston suburbs, Denver, Austin—deserve special attention. 2Q Owners need to stem potential losses by renewing larger ten- Source: National Council of Real Estate Investment Fiduciaries (NCREIF). ants at current market rents, while trying to limit new lease terms *2003 returns are four-quarter trailing figures as of second-quarter 2003. to five years. “If successful, they can prevent further downside, expensive leasing commissions, and costly tenant work, and be well positioned when rents start to recover.” Landlords will have Exhibit 5-20 Office Vacancy Rates a tougher time in Chicago, Houston, Dallas, and Atlanta “where tenants have ample relocation choices.” 25%

Avoid CBD Don’t buy anything with near-term leasing exposure unless you 20% Suburban underwrite deteriorating fundamentals into your pricing. And be wary of “tweener” investments. These buildings have currently strong occupancy and cash flows but may face underly- 15% ing rollover risk—either tenant quality is suspect or lease terms end in the next two to three years. “These aren’t trophies—they could be vulnerable if markets stay down and owners have 10% leveraged them up.”

5% Development ´88 ´89 ´90 ´91 ´92 ´93 ´94 ´95 ´96 ´97 ´98 ´99 ´00 ´01 ´02 ´03 Projects are getting pulled off the drawing boards. “It will be 2Q [four to five] years before new office is needed” in most mar- Source: Torto Wheaton Research. kets. Discount to replacement cost and falling rents make it impossible to justify anything except build-to-suit construction, risk is considerable during the next three years—recovery will and few companies can even think about new headquarters be slow going unless the economy sprints. In most markets, projects in the current rein-in-expenses environment. supply swamps demand. Warehouses and apartments look better and better.” Outlook For 2004, revenues erode and values decline. Concession packages will keep real rents from stabilizing until 2005, and any income growth may be delayed until 2006 or 2007. “Rollover

51 Hotels are “the best higher-risk play,” but there are “very few steals.”

aged in the 1990s, and operating efficiencies have steadily low- Hotels ered break-even industry occupancy rates to under 50 percent. Strengths Operators have learned to make money with less, using technology and cutting corners on service. That is especially good news Abundant capital searches for deals, propping up prices and for investors, since occupancies continue to fluctuate uncom- disappointing bottom fishers, who hope for bigger discounts. fortably below 60 percent. Development remains modest— “Hotels may not be a contrarian pick after all.” Expect minimal room starts have plunged from late-1990s highs, offering a win- distressed selling. In general, owners are well capitalized and can dow for improving occupancy rates if business travel increases. hold investments through any downturn. The industry delever- Revenues may be slower to follow. Leisure travel strengthens— and Americans stay closer to home, giving domestic resort loca- Exhibit 5-21 Full-Service Hotel Summary 2004 tions an edge over international destinations.

RATING RANKING Weaknesses Investment Potential 4.4 5th (Tie) “Hotels really are at bottom.” Many travelers wait until the last Buy 45% Development Potential 2.5 8th minute and scavenge discounts over the Internet—reducing Overbuilding Risk 5.7 6th operator-pricing power. The essential business-travel component lags. Companies tighten the tourniquets on travel and meeting PREDICTED VALUE GAIN/LOSS Sell 22% budgets—that is low-hanging fruit for the corporate bean coun- 1 Year 5 Years 10 Years ters. “Greater thrift may be here to stay for a while.” Employee Hold 33% relocations and training conferences have also been slashed. 2.0% 12.6% 23.3% Ill-fated timing has hurt some hotels built in large metropolitan areas during the late-1990s construction wave. Demand softened in 9/11’s aftermath. Then the war in Iraq and SARS short-circuited a nascent recovery. Now, chronic undercurrents Exhibit 5-22 Limited-Service Hotel Summary 2004 of world turmoil threaten to sap an upswing. Keeping domestic terror at bay is essential for these properties. Visitors from overseas are less plentiful, in spite of favorable exchange rates. RATING RANKING Buy 24% Basically, hotels have been “limping along.” Staffing layoffs help Investment Potential 3.5 7th maintain profitability, but guests notice some decline in service. Development Potential 2.4 9th Overbuilding Risk 6.7 1st Sell 39% Best Bets PREDICTED VALUE GAIN/LOSS Hotels are “the best higher-risk play,” but there are “very few 1 Year 5 Years 10 Years steals.” Buyers need to make sure they retain the flexibility to Hold 37% change flags, and deferred maintenance could be an issue— 0.6% 9.8% 20.1% “nobody has been doing much upgrading lately.” It is purely an opportunity investment; “you buy and sell in the cycle.” Focus on full-service in the stronger 24-hour markets and subcities. Sound familiar?

52 Avoid Exhibit 5-23 Hotel Construction Put in Place Hospitality holdings are not a core play for institutional investors craving income predictability. “All they add to your 20,000 portfolio is volatility.” Pension funds continue to shy away from direct hotel ownership. “I don’t like the ups and downs or the business—dealing with the management companies.” 15,000 Limited-service product in high-growth areas is more vulnerable to new competition and suburban degeneration. “You never see them on institutional investor shopping lists.” 10,000

Development Millions of Dollars Markets continue to digest overbuilding—“we don’t need new 5,000 hotels anywhere”—but project activity is forecast to increase in 2004 and 2005. Less would be more. 0 ´93 ´95 ´97 ´99 ´01 Jul 03

Outlook Source: U.S. Census Bureau. Hope fades for “material improvement in 2004,” although the lodging industry can bounce back quickly if road warriors return to action. Terrorism fallout and global conflict will continue to raise background fears and uncertainties, grounding travel at least on the margins. “Timing a recovery is problematic.” Demand “may be structurally compromised for a while” by business frugality and frayed nerves.

53 Interview/Survey Participants AEW Capital Management, L.P. Champion Partners East West Partners–Western Division Michael J. Acton Jeff Swope Harry H. Frampton III Joseph F. Azrack Douglas M. Poutasse Childress Klein Properties Ernst & Young LLP J. Donald Childress Dale Anne Reiss AMB Property Corporation Luis A. Belmonte Citistates Group First Fidelity Mortgage Corporation Tyler W. Higgins Peter Katz Lance Patterson Guy Jaquier David C. Twist Cohen & Steers Capital Management First Industrial Realty Trust Robert Steers James D. Carpenter American Realty Advisors Scott W. Darling Colony Capital, LLC Florida State Board of Administration Scott M. Holmes Richard B. Saltzman Douglas W. Bennett Brook Wells Columbus Properties, L.P. Forest City Enterprises AMLI Residential Properties Trust Joseph C. Canizaro James A. Ratner Allan J. Sweet Column Financial, Inc. Fremont Realty Capital Berwind Property Group, Ltd. Kieran P. Quinn Claude J. Zinngrabe, Jr. Joseph I. Neverauskas Arthur P. Pasquarella Commercial Mortgage Alert GE Real Estate Paul Florilla Michael G. Rowan BNP Residential Properties, Inc. Dan Smith Phillip S. Payne Commercial Mortgage Securities Association GMAC Institutional Advisors Brandywine Realty Trust Dorothy Cunningham Robert A. Fabiszewski George Hasenecz Kurt Wright Commercial Net Lease Realty, Inc. Bristol Group, Inc. Gary M. Ralston Goldman Sachs & Company James J. Curtis III Daniel M. Neidich Continental Development Buzz McCoy Associates, Inc. Corporation Great Point Investors Bowen H. McCoy Alex J. Rose Joseph Versaggi

California Public Employees’ Crescent Real Estate Equities, Ltd. Green Courte Partners, LLC Retirement System (CalPERS) Jeanette I. Rice Randall K. Rowe Michael McCook Cushman & Wakefield, Inc. The Greenwich Group California State Teachers’ Retirement Timothy J. Welch R. Gary Barth System (CalSTRS) Michael J. Thompson Delaware Investment Advisers Heitman Financial Walter Korinke Richard Kateley CBL & Associates Properties, Inc. Keith Honnold Deutsche Asset Management HIGroup LLC Donald A. King, Jr. Douglas H. Cameron CB Richard Ellis William C. Yowell III DivcoWest Properties Hines Stephen J. Pilch Thomas Owens CDP Capital Real Estate Advisory Frank Creamer Donahue Schriber Host Marriott Corp. Thomas L. Schriber John Boetiger CenterPoint Properties Trust John S. Gates, Jr. DRA Advisors The Howard Hughes Corporation Francis X. Tansey Daniel C. Van Epp

54 Hyde Street Holdings, Inc. Lehman Brothers Ohio Public Employees’ Patricia R. Healy Michael McNamara Retirement System Raymond C. Mikulich Mary Beth Shanahon ING Clarion Partners Stephen J. Furnary LEM Mezzanine, LLP PacTrust Stephen B. Hansen Herb Miller David W. Ramus Will McIntosh Lend Lease Mortgage Capital Prentiss Properties Trust Institutional Real Estate, Inc. Edward L. Hurley Tom August Geoffrey Dohrmann Lend Lease Real Estate Investments Principal Real Estate Investors INVESCO Realty Advisors, Inc. Waldemar Antoniewicz Michael J. Lara Paul Curbo Scott Brown Steve Walker Richard Burns ProLogis Mark Degner John Frandson JP Morgan Fleming Peter Harned Joseph Azleby Theodore Klinck Property & Portfolio Research Inc. David Esrig M. Leanne Lachman Susan Hudson-Wilson Kevin Faxon Hugh McWhinnie Michael Giliberto James Ryan Prudential Investment Management Ellie Kerr Joe Thomas Gary L. Kauffman Youguo Liang The John Buck Company Lend Lease Rosen Real Estate Charles F. Lowrey Charles R. Beaver Securities Joseph D. Margolis Michael Torres Roger S. Pratt Jones Lange LaSalle Inc. J. Allen Smith Bruce Ficke Lowe Enterprises Community Dale H. Taysom Development JSS Advisors, LLC James DeFrancia The Real Estate Roundtable Joyce Steves Storm Jeffrey D. DeBoer Lowe Enterprises, Inc. Kennedy & Associates Theodore Leary, Jr. Regent Partners Brent Palmer Ronald Silva David Allman Preston Sargent Merrill Lynch Riggs Bank Klingbeil Capital Management Martin J. Cicco Patrick Mayberry James Klingbeil Morgan Stanley Robert Charles Lesser & Company, Koll Bren Schreiber Realty Associates Owen D. Thomas LLC Charles Schreiber, Jr. Gadi Kaufmann National Association of Real Estate LaSalle Investment Management Investment Trusts Rockwood Realty Associates William J. Maher Steven A. Wechsler R. John Wilcox II

Lazard Freres Real Estate Investors, New Plan Excel Realty Trust Rosen Consulting Group LLC Glen J. Rufrano Arthur B. Margon Robert C. Larson New York State Teachers’ Retirement RREEF Legacy Partners Commercial, Inc. System (NYSTRS) Charles B. Leitner III Barry DiRaimondo James D. Campbell Sabey Corporation Legg Mason Inc. Northwestern Investment Management Jim Harmon Glenn R. Mueller Company David Sabey Eugene R. Skaggs

55 Secured Capital Corp. UBS Global Asset Management W.P. Carey & Co. LLC Christopher M. Casey Lijian Chen Heather R. Bentley William Polk Carey The Shaw Group UBS Realty Investors LLC Charles H. Shaw Dan Leary York Properties, Inc. Jim O’Keefe Smedes York Simon Property Group Richard S. Sokolov University of California at Berkeley Kenneth T. Rosen Sonnenblick-Eichner Company David Sonnenblick University of Pennsylvania– Wharton School of Business Sonnenblick-Goldman Peter D. Linneman Steven A. Kohn Arthur Sonnenblick Vestar Development Co. Lee T. Hanley SSR Realty Advisors William Finelli Vornado Realty Trust Thomas Leyden Michael D. Fascitelli Fred Lieblich Barry A. Ziering Wachovia Bank, N.A. Mark Midkiff State of Michigan Retirement System Jon M. Braeutigam Washington Real Estate Investment Trust St. Joe Company Thomas Regnell Peter S. Rummell Watson Land Company Tarragon Realty Investors, Inc. Bruce A. Choate William S. Friedman WCB Properties Tennessee Consolidated Retirement Ed D’Orio System Sean M. Tabor Peter L. Katseff Wells Fargo Bank TIAA/CREF A. Larry Chapman Alice M. Connell Wells Real Estate Funds Timbervest, LLC Don Miller Jerry Barag David Steinwedell

Trammell Crow Residential Westfield Capital Partners J. Ronald Terwilliger Ray H. D’Ardenne

Trinity Real Estate, Inc. Westfield Corporation, Inc. Richard T. Leider Peter F. Koening John C. Schroder Trizec Properties, Inc. Timothy H. Callahan The Winter Group of Companies, Inc. Robert L. Silverman

56 Advisory Board for 2004 Joseph Azrack Mike Miles AEW Capital Management Guggenheim Real Estate Boston, Massachusetts Winchester, Massachusetts

John C. Cushman III James O’Keefe Cushman and Wakefield, Inc. UBS Realty Investors LLC Los Angeles, California Hartford, Connecticut

Mark Eppli Ken Rosen Marquette University College of Business Administration Fisher Center for Real Estate and Urban Economics Milwaukee, Wisconsin Haas School of Business University of California Stephen J. Furnary Berkeley, California ING Clarion Partners New York, New York Richard B. Saltzman Colony Capital, LLC David Geltner New York, New York University of Cincinnati Cincinnati, Ohio C.F. Sirmans University of Connecticut Jaques Gordon Storrs Mansfield, Connecticut LaSalle Investment Management Chicago, Illinois James R. Webb Cleveland State University College of Business Joseph Gyourko Cleveland, Ohio The Wharton Real Estate Center University of Pennsylvania Philadelphia, Pennsylvania

Susan Hudson-Wilson Property & Portfolio Research Boston, Massachusetts

57 Sponsoring Organizations Urban Land $ Institute

ULI–the Urban Land Institute is a nonprofit research and education PricewaterhouseCoopers real estate group assists real estate investment organization that is supported by its members. Its mission is to provide advisers, REITs, public and private real estate investors, corporations, responsible leadership in the use of land in order to enhance the total and real estate management funds in developing real estate strategies; environment. evaluating acquisitions and dispositions; and appraising and valuing The Institute maintains a membership representing a broad spec- real estate. Its global network of dedicated real estate professionals trum of interests and sponsors a wide variety of educational programs enables it to assemble for its clients the most qualified and appropriate and forums to encourage an open exchange of ideas and sharing of team of specialists in the areas of capital markets, systems analysis and experience. ULI initiates research that anticipates emerging land implementation, research, accounting, and tax. use trends and issues and proposes creative solutions based on this research; provides advisory services; and publishes a wide variety of materials to disseminate information on land use and development. Established in 1936, the Institute today has more than 18,000 Real Estate Leadership Team members and associates from some 70 countries, representing Patrick R. Leardo the entire spectrum of the land use and development disciplines. Global Real Estate Business Advisory Services Professionals represented include developers, builders, property own- New York, New York ers, investors, architects, public officials, planners, real estate brokers, 646-471-2666 appraisers, attorneys, engineers, financiers, academics, students, and librarians. ULI relies heavily on the experience of its members. It is Robert K. Ruggles, III through member involvement and information resources that ULI has Real Estate Valuation Advisory Services been able to set standards of excellence in development practice. The New York, New York Institute is recognized internationally as one of America’s most respect- 201-689-3101 ed and widely quoted sources of objective information on urban planning, growth, and development. Peter F. Korpacz Global Strategic Real Estate Research Group Baltimore, Maryland Senior Executives 301-829-3770 Richard M. Rosan www.pwc.com President

Cheryl Cummins Executive Vice President

Rachelle L. Levitt Senior Vice President, Policy and Practice

ULI–the Urban Land Institute 1025 Thomas Jefferson Street, N.W. Suite 500 West Washington, D.C. 20007 202-624-7000 www.uli.org

58 Emerging Trends in Real Estate® 2004 Highlights What are the best bets for development in 2004? Based on ■ Tells you what to expect and where the best opportunities are. personal interviews and surveys from more than 300 of the most influential leaders in the real estate industry, this forecast ■ Describes trends in the capital markets, including sources gives you the heads-up on where to invest, what to develop, and flows of equity and debt. which markets are hot, and how the economy, the threat of terrorism, technology, and trends in capital flows will affect ■ Advises you on those metropolitan areas that offer the real estate. A joint undertaking of PricewaterhouseCoopers most potential. and the Urban Land Institute, and highly regarded in the industry, Emerging Trends is the forecast you can count on ■ Tells you which property sectors offer opportunities and for no-nonsense, expert advice. which ones you should avoid.

■ Reports on how the economy and concerns about job growth are affecting real estate.

■ Describes the impact of terrorism and global geopolitical uncertainty.

■ Explains the current impacts of technology on real estate.

Urban Land $ Institute www.pwc.com www.uli.org

ULI Order Number: E18 ISBN: Pending